Can Mutual Funds Own Stocks Under $5?

It's often said that mutual funds and other institutional investors can't own stocks that trade for less than $5, condemning low-priced stocks to retail ownership only. But the truth is actually the opposite -- there are some roadblocks for investing in penny stocks, but they are most applicable to average Joes, not professional investors who run institutional sums.

Why share prices matter (and why they don't)

Mathematically, a company worth $10 billion is still worth $10 billion, whether it is sliced into $1 shares or $1,000 shares. However, the government takes a different view due to laws passed to thwart bad brokerage practices.

Congress put share prices in the spotlight when it made it more difficult for brokers to process client transactions in stocks priced lower than $5 each, the cutoff point below which a stock earns the "penny stock" label.

These regulations were put into place following a broad crackdown on sketchy stock brokers in the early 1990s. Back then, brokerages sold penny stocks of questionable quality to investors all around the country by phone, charging huge commissions on each trade.

These folks weren't bad at picking good stocks, but rather good at selling bad stocks. One of the largest busted brokerages was J.T. Moran, which was the basis for the story in the movie Boiler Room. Stratton Oakmont, featured in Wolf of Wall Street, fits the description, too. You get the idea here.

How Congress dealt with penny stock salesmen

Congress decided that it needed to make it harder for individual investors to buy bad stocks, deciding to make $5 the dividing line between "good" and "bad" stocks. And with new rules in place, it immediately became all that much harder for brokers to pitch stocks that trade for less than $5 per share.

According to the Securities and Exchange Commission, brokers can't process trades in stocks worth less than $5 without following a laundry list of rules and processes. Before transacting in penny stocks, brokers must first:

  1. Approve the customer for the transaction
  2. Receive a written agreement for the transaction
  3. Provide the customer a disclosure statement that describes the risk of investing in penny stocks
  4. Disclose the current market price for the stock
  5. Disclose how much the firm and broker will receive for processing the trade

The rules are reflective of the times in which they were adopted. In the 1980s and 1990s, commissions were generally assessed on a per-share basis, rather than on a flat fee basis that is the standard today. Thus, brokers made more by selling 2,000 shares of a $1 stock than 10 shares of a $200 stock, which is why penny stocks were commonly pitched by the sleaziest of stockbrokers, and why Congress targeted penny stocks with legislation.

What about institutional investors?

Mutual funds and other institutional investors may choose to avoid stocks priced at less than $5 per share, but there are no specific rules or laws prohibiting the practice.

In fact, one of the largest actively managed stock funds on the market today is the Fidelity Low-Priced Stock Fund (NASDAQMUTFUND: FLPSX), which specifically seeks to invest in stocks priced at less than $35 per share. It launched in 1989 at the height of the public's love affair with low-priced stocks, and has crushed the market since inception. (Its focus on low-priced stocks may be more of a guide than a rule today, since its five largest investments all trade for more than $35 per share, a testament to the fact that self-imposed restrictions are rarely set in stone.)

Of course, index funds are more prominent today than in the past, and many have a mandate to own all stocks in the index they track, regardless of share prices. The S&P 500 Index, and the funds that track it, all have at least one penny stock in their portfolio, Chesapeake Energy. The Russell 2000 Index, which is generally regarded as the small cap stock index, includes 157 penny stocks, based on my analysis of the iShares Russell 2000 ETF.

Realistically, penny stocks don't make up a large part of the market in terms of value, but they are numerous, and many are owned by funds because share prices are largely irrelevant to the decision to buy or sell. Professional investors know that a stock that trades for $4 that they believe to be worth $10 is a far better investment than a $40 stock they believe to be worth $50.

The next time someone tells you that a stock that has dropped will drop even further when institutions are forced to sell below $5, refer them to this article. Though the average Joe may face a few hurdles when buying or selling stocks under $5, there is no meaningful institutional bias against stocks that trade for less than $5 each. In fact, thanks to the rise of index funds, there are perhaps more funds that are required by their mandate to buy penny stocks than funds that purposefully exclude them.

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