Mutual funds, by law, are required to maintain certain levels of diversification and be operated in the best interest of the public. They are sponsored and operated by investment management companies, which fall under the supervision and regulation of the Securities and Exchange Commission (SEC).
Diversification seeks to allocate money over a wide number of securities. The most notable reason for this is to reduce the risk of having too much money concentrated in too few stocks. If any one security were to fail, not all would be jeopardized.
The more important reason for diversification is a regulatory one. Mutual funds began to gain prominence shortly before the market crash of 1929, and some funds wielded too much control over securities.
Legislative Acts by Congress
The Securities Act of 1933 established federal rules that addressed the manner in which securities are registered. The Securities Exchange Act of 1934 addressed rules pertaining to how securities can be actually traded.
Investment Company Act of 1940
This legislative act directly addressed the governance of investment management companies that operate mutual funds. Since the mutual fund industry was still fairly young, assurances were implemented so that the public's interests would be protected and held to the highest standard.
Details of the 1940 Act
Principal features of this act require that any investment management company (mutual funds are the most common type) can not own more than 10 percent of a company's publicly traded stock, and also that not more than 5 percent of the funds assets can be invested in any one security. These two specific rules apply to 75 percent of a mutual fund portfolio. The remainder has no restrictions.
The legislative action pertaining to mutual funds resulted in mutual funds being forced to be diversified. In practice, however, the amount of assets a mutual fund receives from shareholders makes it virtually necessary for mutual funds to own hundreds of securities--far beyond what is required.
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