Amazon stock performance screen shot (Photo: AP)

The Securities and Exchange Commission has granted no-action relief to allow index funds to become non-diversified as a result of market changes to the underlying index components.

Without the relief, according to Cipperman Compliance Services, “an index fund that tracks a third-party index would have to obtain shareholder approval to change its status from diversified to non-diversified when certain underlying component securities increased in value such that they would make up more than 5% of the portfolio.”

Cipperman stated that the non-diversified issue “has dogged large index funds and ETFs for the last couple of years as the FAANG securities have increased in market value as compared to other index components.”

FAANG refers to the market’s five most popular and best-performing tech stocks — Facebook, Apple, Amazon, Netflix and Alphabet’s Google.

The relief would require prospectus disclosure that the fund could become non-diversified during these periods, Cipperman said, and the fund would still be constrained by the diversification requirements of the tax code and the applicable exchange on which it is traded.

The SEC’s Monday no-action letter was written in response to a request from Stradley Ronon. The law firm told the securities regulator that in the past year, a few constituents of certain large-cap U.S. equity growth broad-based indexes have grown to each represent more than 5% of those indexes — in some cases, more than 25%.

As a result, index-based funds that track those indexes and hold themselves out as diversified companies “may become non-diversified companies, as defined in Section 5(b)(2) of the 1940 Act.”

The law firm’s concern is “that an index-based fund, solely as a result of tracking its target broad-based index, would cease to be a diversified company as a result of a change in relative market capitalization or index weighting of one or more constituents of the index,” according to the letter.

Stradley Ronon said the “relief is consistent with the expectations of investors in an index-based fund, will minimize portfolio disruption and unnecessary costs, and will provide appropriate investor protections, including disclosure.”