Mutual Fund 5 dollar rule states that mutual funds are not allowed to invest in equity stocks below the share price of 5 $. This is because the penny stock limit is $5 set by the IIRC.

I have often head that many mutual funds are not allowed to invest in equity stocks below the share price of $5. I though that did not make any sense because total market capitalization is the actual benchmark. Whether a company issues a million shares of stock at $5 or two million shares of stock at $2.5, did not seem to make much of a difference.

In my understanding mutual funds if forbidden from investing in a company because of its low market capitalization made sense. Why should price be a criteria I thought?

I later realized that even the brokers were not allowed to recommend a penny stock unless the customer specifically said okay to it. If a stock broker cannot recommend a penny stock, it was obvious why a mutual fund would not recommend it. Especially because the first rule of a mutual fund investment is to reduce the risks of investing.

To quote this article  :

Mutual funds draft their own charters, and some choose to avoid stocks under $5 a share. However, they are not obligated to do so, except for fiduciary reasons. Many mutual funds specify that they will hold only stocks listed on the NYSE or the Nasdaq National Market. Furthermore, unless the fund explicitly specializes in small-cap/high-risk shares, holding penny stocks may be bad for business because they are perceived as an unwarranted financial risk for investors.

SEC Penny Stock Rules:

The term “penny stock” generally refers to low-priced (below $5), speculative securities of very small companies. While penny stocks generally are quoted over-the-counter, such as on the OTC Bulletin Board or in the Pink Sheets, they may also trade on securities exchanges, including foreign securities exchanges. In addition, penny stocks include the securities of certain private companies with no active trading market.

So now you know what a Mutual Fund 5 dollar rule is.