[Federal Register Volume 60, Number 64 (Tuesday, April 4, 1995)]
[Proposed Rules]
[Pages 17172-17181]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-8143]
[[Page 17171]]
_______________________________________________________________________
Part V
Securities and Exchange Commission
_______________________________________________________________________
17 CFR Part 239 et al.
Improving Descriptions of Risk by Mutual Funds and Other Investment
Companies; Proposed Rule
Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 /
Proposed Rules
[[Page 17172]]
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 239, 270, and 274
[Release Nos. 33-7153; 34-35546; IC-20974; File No. S7-10-95]
RIN 3235-AG43
Improving Descriptions of Risk by Mutual Funds and Other
Investment Companies
AGENCY: Securities and Exchange Commission.
ACTION: Concept release; request for comments.
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SUMMARY: The Securities and Exchange Commission (the ``SEC'' or
``Commission'') is seeking comments and suggestions on how to improve
the descriptions of risk provided to investors by mutual funds and
other management investment companies (``funds'' or ``investment
companies''). In order to encourage individual investor comments and
suggestions, the SEC is including in the Release an appendix directed
to investors, which the SEC intends to reprint separately and
distribute to investors.
DATES: The SEC requests comments on or before July 7, 1995.
ADDRESSES: Three copies of your comments should be submitted to
Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450
Fifth Street NW., Washington, D.C. 20549. All comment letters should
refer to File No. S7-10-95. All comments received will be available for
public inspection and copying in the SEC's Public Reference Room, 450
Fifth Street NW., Washington, D.C. 20549. If you are an individual
investor and do not have access to a copier machine, you may send in
one copy of your comments.
FOR FURTHER INFORMATION CONTACT: Susan Nash, Senior Special Counsel,
(202) 942-0697, Paul B. Goldman, Chief Financial Analyst, (202) 942-
0510, Roseanne Harford, Senior Counsel, (202) 942-0689, Martha H.
Platt, Senior Counsel, (202) 942-0725, in the Division of Investment
Management, or Craig McCann, Professional Fellow, (202) 942-8032,
Office of Economic Analysis.
SUPPLEMENTARY INFORMATION:
Executive Summary
Today the SEC is continuing its efforts to enhance the information
that investors in funds receive to assist them in making an informed
investment decision. In recent years, the SEC has taken significant
steps designed to improve the understandability and comparability of
fund disclosure of performance and expenses.\1\ The SEC is now
requesting comment on how to improve risk disclosure for investment
companies, including ways to increase the comparability of disclosure
about funds' risk levels through quantitative measures or other
means.\2\
\1\See, e.g., Disclosure of Mutual Fund Performance and
Portfolio Managers, Investment Company Act of 1940 (``Investment
Company Act'') Rel. No. 19382 (Apr. 6, 1993) [58 FR 19050 (Apr. 12,
1993)] (requiring mutual fund prospectuses or annual reports to
discuss performance and provide line graph comparing fund
performance to that of an appropriate market index over the last ten
fiscal years; financial highlights table of prospectus revised to
include total return information and generally to provide investors
with information showing the performance of funds on a per share
basis); Registration Form for Closed-End Management Investment
Companies, Investment Company Act Rel. No. 19115 (Nov. 20, 1992) [57
FR 56826, 56829 (Dec. 1, 1992)] (improvements to financial
highlights table for closed-end funds; fee table providing standard
format for expense information required in closed-end fund
prospectuses); Advertising by Investment Companies, Investment
Company Act Rel. No. 16245 (Feb. 2, 1988) [53 FR 3868 (Feb. 10,
1988)] [hereinafter ``Rel. 16245''] (mutual fund advertisements and
sales literature containing performance data required to include
uniformly computed performance data); Consolidated Disclosure of
Mutual Fund Expenses, Investment Company Act Rel. No. 16244 (Feb. 1,
1988) [53 FR 3192 (Feb. 4, 1988)] (fee table required in mutual fund
prospectuses).
\2\The SEC requested comment on methods for disclosing risk in
1993 when it proposed rule amendments that would have given
investors the option of purchasing mutual fund shares based on a
short form prospectus. Off-the-Page Prospectuses for Open-End
Management Investment Companies, Investment Company Act Rel. No.
19342 (Mar. 19, 1993) [58 FR 16141, 16145 (Mar. 25, 1993)]
[hereinafter ``Rel. 19342'']. In particular, the SEC asked whether
the short form prospectus should be required to contain a
standardized presentation of the degree and kind of risk presented
by a mutual fund relative to other mutual funds. A limited number of
comments were received on this topic, with the comments being almost
evenly divided whether standardized risk disclosure should be
required. See Summary of Comment Letters Relating to Proposed Rule
482(g) Made in Response to Investment Company Act Release No. 19342,
File No. S7-11-93, Jan. 27, 1994, at 17-18 [hereinafter ``Summary of
Comments: Rel. 19342''].
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Under existing SEC rules, a fund is required to discuss in its
prospectus the principal risk factors associated with investing in the
fund.3 Funds typically describe the risks of investing in the fund
by describing the risks of particular investment policies that the fund
may use and investments that the fund may make.4 Lengthy and
highly technical descriptions of permissible policies and investments
that are often used in meeting existing requirements may make it
difficult for investors to understand the total risk level of a fund.
The SEC staff has found that funds typically provide only the most
general information on the risk level of the fund taken as a whole and
has encouraged funds to modify their existing disclosure to enhance
investor understanding of risks.5 The SEC believes that it is now
appropriate to explore whether SEC disclosure requirements should be
revised in order to improve the communication of fund risks to
investors and increase the likelihood that investors will readily grasp
the risks of investing in a particular fund before they invest.
\3\Risk factors include those peculiar to the fund and those
that apply generally to funds with similar investment policies and
objectives or, in the case of closed-end funds, similar capital
structures or trading markets. Item 4(c), Form N-1A, & Guide 21,
Disclosure of Risk Factors, Guidelines for Form N-1A [17 CFR 239.15A
& 274.11A] (mutual funds); Item 8.3.a., Form N-2 [17 CFR 239.14 &
274.11a-1] (closed-end funds).
\4\See Form N-1A, Item 4(a)(ii) (requires concise description of
mutual fund investment objectives and policies and brief discussion
of how the fund proposes to achieve such objectives, including
description of the securities in which the fund will invest and
special investment practices or techniques that will be employed);
Form N-1A, Item 4(b) (requires discussion of types of investments,
policies, and practices that will not constitute the ``principal
portfolio emphasis'' of a mutual fund, but which place more than 5%
of the fund's net assets at risk); Form N-2, Item 8.2. & 8.4.
(similar requirements for closed-end funds).
\5\See Memorandum dated Sept. 26, 1994, from Division of
Investment Management to Chairman Levitt regarding Mutual Funds and
Derivative Instruments 11 [hereinafter ``Derivatives Report''];
Letter to Registrants from Carolyn B. Lewis, Assistant Director,
Division of Investment Management 7 (Feb. 25, 1994) (both documents
on file with the SEC's Public Reference Room).
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Several factors make it important that the SEC explore better ways
of explaining fund risks to investors. First, average Americans are
placing increasing reliance on funds to meet important financial needs,
such as retirement and college expenses.6 Understanding the risks
of various investment products is one of the most important ingredients
in creating an overall investment strategy or portfolio to meet these
financial needs.7 Second, [[Page 17173]] new ways of describing
risks may improve investor understanding of the risks associated with
the use by some funds of increasingly complex instruments, such as
derivatives.8 Third, the number and types of funds have
proliferated, increasing fund investors' need for information that will
help them to compare and contrast alternatives.9
\6\According to a June 1994 survey sponsored by the Investment
Company Institute, 31% of United States households owned shares in a
mutual fund, up from 6% of households in 1980. Investment Company
Institute, Fundamentals (Sept. 1994); Investment Company Institute,
1994 Mutual Fund Fact Book 85 (34th ed. 1994) [hereinafter ``1994
ICI Fact Book'']. Mutual funds held 14.9% of all household
discretionary assets as of June 30, 1994, up from 7.0% at the end of
1982. Source: Investment Company Institute. Total mutual fund assets
have grown from $292.9 billion at the end of 1983 to $2.16 trillion
at the end of December 1994. 1994 ICI Fact Book, supra, at 26;
Investment Company Institute Press Release, ``December Mutual Fund
Sales Total $39.9 Billion,'' Jan. 26, 1995, at 4.
By the end of 1993, retirement assets accounted for 23% of
mutual fund assets (excluding variable annuities), and mutual funds
held almost $284 billion of the approximately $857 billion invested
in individual retirement accounts (``IRAs'')--about 33% of total IRA
assets. 1994 ICI Fact Book, supra, at 69.
\7\See, e.g., Burton G. Malkiel, A Random Walk Down Wall Street
ch. 13 (1990) [hereinafter ``Random Walk'']; Susan E. Kuhn, ``What
it Takes to Retire Today,'' Fortune, Dec. 26, 1994, at 113; Joshua
Shapiro, ``The Discipline of Saving for College,'' New York Times,
Sept. 10, 1994, at 34.
\8\See Testimony of Arthur Levitt, Chairman, U.S. Securities and
Exchange Commission, Concerning Issues Affecting the Mutual Fund
Industry, Before the Subcommittee on Telecommunications and Finance,
Committee on Energy and Commerce, U.S. House of Representatives 18-
19 (Sept. 27, 1994); Derivatives Report, supra note 5, at 11-12.
\9\See, e.g., 1994 ICI Fact Book, supra note 6, at 30-31
(increase from 564 mutual funds at the end of 1980 to 4,558 at the
end of 1993; mutual funds classified according to 21 investment
objectives).
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The importance of risk disclosure was underscored last year when
some short-term government bond funds experienced losses as interest
rates increased sharply.10 Shareholders in these funds expressed
surprise at the losses, and several shareholder lawsuits were
filed.11 Whatever the legal merits of the shareholder complaints
may be, the SEC believes that these events highlight the importance of
clear, concise disclosure of risks.
\10\See, e.g., Leslie Eaton, ``Paine Webber to Bail Out Fund
Battered by Complex Investments,'' New York Times, July 23, 1994, at
A1; Robert McGough, ``Piper Jaffray Acts to Boost Battered Fund,''
Wall Street Journal, May 23, 1994, at C1.
\11\See, e.g., Karen Donovan, ``Derivatives Slump; Losers Go to
Court,'' National Law Journal, Nov. 7, 1994, at A1; G. Bruce Knecht,
``Minneapolis Investors Are Hurt By Local Firm They Knew As
Cautious,'' Wall Street Journal, Aug. 26, 1994, at A1; John
Waggoner, ``Mutual Fund Losses Anger Novice Investors,'' USA Today,
June 16, 1994, at 1B.
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In this Release, the SEC requests that those submitting comments
discuss the specific goals of, and various alternatives for, improving
risk disclosure. Comments are requested on the relative merits of
written and other presentations of risk, including quantitative or
numerical measures, graphs, tables, and other pictorial
representations.
The Release describes and requests comment on several specific
quantitative measures of risk and risk-adjusted performance, including
standard deviation, semi-variance, beta, duration, the Sharpe Ratio,
the Treynor Ratio, and Jensen's Alpha. These measures of risk are
potentially useful because they may give investors a tool for balancing
the potential returns of a fund against the risks of the fund. For
instance, if a fund has historical annual returns which are 2% above a
market index, historical risk measures may provide some indication of
the risks that were taken to produce the increased returns.
Quantitative risk measurements may provide investors with tools to
measure how funds have fared historically in the relationship between
risk and return.
The Release also asks for comments addressing a number of general
topics related to quantitative risk measures. These include:
The benefits to be derived from quantitative measures
versus the costs and burdens to the fund that must produce such
information;
Quantitative measures currently used by fund managers to
assess risk, and whether such internally used measures should be
disclosed to investors;
Investor understanding of quantitative measures, and means
to increase that understanding;
Standardizing the ways in which funds calculate
quantitative measures to assure comparability and the validity of any
underlying assumptions; and
Availability of quantitative risk information from third
party providers (e.g., the financial press and rating services).
Comments are also requested on whether funds should be required to
disclose a self-assessment of their risk level, using an SEC-created
standard scale or some other method. In addition, comments are
requested on whether funds should describe to investors the ways or
strategies that fund managers use to manage, understand, and monitor
the risks of their funds.
The SEC requests comments that address the specific questions posed
in this Release as well as alternative risk disclosure methods and
related matters. Where possible, please provide actual rule language
that you believe would best express your recommendation.
To encourage individual investor comments and suggestions on this
Release, the SEC for the first time has prepared a short summary
specifically directed to individual investors. The summary, which
appears as an appendix to the Release, will be reprinted in a format
that leaves space for individual investors to tell the SEC about their
concerns and ideas and distributed through investor groups and other
means designed to reach individual investors.
I. The Goals of Risk Disclosure
The SEC's goal is to improve disclosure of fund risks so that
investors will have the information they need to understand the risk of
any particular fund investment. The best means for achieving this aim
may depend, in part, on the specific goals of risk disclosure. The SEC
therefore requests comment on the specific goals of risk disclosure,
including the matters raised below.
The SEC asks persons submitting comments to define, as precisely as
possible, what ``risks'' should be disclosed to investors. To what
extent are investors concerned with the likelihood that they will lose
principal, that their return will not exceed a specified benchmark
(such as the Standard & Poor's (``S&P'') 500), or with the variability
of their returns (or the volatility of the value of their investment)
over time? How should the relationship between risk and an investor's
time horizon shape the disclosure that is provided to investors? For
example, is the same risk information useful to an investor with an
investment time horizon of less than one year and to an investor with
an investment time horizon of twenty years?12 How can the
disclosure of risk help investors answer the fundamental questions--Is
this investment suitable for me? If I have diversified my investments,
how does this particular fund fit into my diversification strategy?
\12\See Letter to Barry P. Barbash, Director, Division of
Investment Management, from Paul Schott Stevens, General Counsel,
Investment Company Institute 3-4 (Jan. 19, 1995) [hereinafter ``ICI
Letter''] (on file with the SEC's Public Reference Room) (discussing
different concepts of risk); Paul A. Samuelson, ``The Long-Term Case
for Equities and How it Can be Oversold,'' Journal of Portfolio
Management 15-24 (Fall 1994) (raising questions about common wisdom
that, for long-term investor, stocks will outperform bonds or cash).
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Comments are requested on the nature of risk comparisons that are
useful to investors. For example, should risk disclosure facilitate
comparison among a broad range of investment options, such as between
funds and other investment products? Or is it sufficient to facilitate
comparisons among all funds and fund types, both equity and fixed
income? Or among all equity funds, on the one hand, and all fixed
income funds, on the other? Or only within groups of funds with similar
investment objectives and policies, such as short-term government bond
funds?
Is improved disclosure of risks equally important for equity, fixed
income, and balanced or asset allocation funds? Do recent derivatives-
related losses by some fixed income funds, and the apparently greater
use of derivatives by fixed income funds, suggest that the need for
improved disclosure of risks is greater for fixed income funds?13
In [[Page 17174]] light of the substantive limits on permitted money
market fund investments,14 should risk disclosure requirements for
money market funds be different from those applicable to other
funds?15
\13\See supra notes 10 and 11 and accompanying text. A recent
industry survey of non-money market funds indicated that the level
of derivatives use varied by fund type, with fixed income funds
accounting for 84% of the total market value of all derivatives held
by reporting funds and 62% of the total national amount. Investment
Company Institute, Derivative Securities Survey 6 (Feb. 1994).
Survey respondents included 52 fund complexes with 1,728 non-money
market funds holding aggregate net assets of $958 billion (76% of
industry assets in non-money market funds). Id. at 4.
\14\Mutual funds are prohibited from calling themselves money
market funds unless they comply with the risk-limiting provisions of
rule 2a-7 under the Investment Company Act. These provisions are
designed to limit a fund's exposure to credit, interest rate, and
currency risks. 17 CFR 270.2a-7(b), (c)(2)-(4), & (d).
\15\Losses in the value of certain adjustable rate notes held by
some money market funds recently resulted in the funds' advisers
electing to take actions designed to prevent the funds' per share
net asset values from falling below $1.00; and one small,
institutional money market fund liquidated and redeemed its shares
at less than $1.00 as a result of such losses. See, e.g., ``A
History of Stepping up to the Plate,'' Fund Action, Sept. 12, 1994,
at 9; Brett D. Fromson, ``Losses on Derivatives Lead Money Fund to
Liquidate,'' Washington Post, Sept. 28, 1994, at F1. These losses,
however, raise concerns about the appropriateness of the funds'
investments in some types of adjustable rate securities and not
merely risk disclosure concerns. See Revisions to Rules Regulating
Money Market Funds, Investment Company Act Rel. No. 19959,
Sec. II.D.2.d. (Dec. 17, 1993) [58 FR 68585, 68601-02 (Dec. 28,
1993)] [hereinafter ``Rel. 19959''] (certain types of adjustable
rate notes not appropriate investments for money market funds). See
also Letter from Barry P. Barbash, Director, Division of Investment
Management, to Paul Schott Stevens, General Counsel, Investment
Company Institute (June 30, 1994) (on file with the SEC's Public
Reference Room).
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Comments are also requested on the degree of detail regarding fund
risk that ideally would be communicated to investors. In meeting
existing disclosure requirements, funds often describe the purposes of
using particular types of instruments and the risks associated with
each type, but typically provide only the most general information on
the risk level of the fund taken as a whole.16 Should disclosure
convey the risks of each particular type of instrument held by a fund,
the risks of broader classes of instruments (for instance, derivatives
as a group), the risks of the fund's portfolio as a whole, or some
combination of the foregoing? Should the focus of disclosure be shifted
from the characteristics of particular securities to the nature of the
investment management services offered, including the objectives of a
fund manager and the associated risks and rewards? Do investors need to
understand separately the different types of risk, such as market,
credit, legal, and operational risks, or is it the aggregate effect of
different types of risk that is important to an investment decision?
\16\See Derivatives Report, supra note 5, at 11.
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II. Narrative and Non-Narrative Risk Disclosure Options
The SEC currently requires fund prospectuses to include narrative
descriptions of risk,17 and the SEC is interested in the potential
for improving risk disclosure through changes to the narrative
disclosure requirements and the use of non-narrative forms of
disclosure. The SEC therefore asks persons submitting comments to
discuss the contributions that both narrative and non-narrative forms
of disclosure can make to investor understanding of risk and to provide
the SEC with the findings of any relevant market research on the
effective communication of risk.
\17\See supra notes 3 and 4 and accompanying text.
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At present, a number of funds voluntarily supplement narrative
descriptions of risk through means such as quantitative measures,
graphs, tables, and other pictorial representations. For example, some
funds provide quantitative risk measures like those described in
section III.A. of this Release. Another method used is a line graph
that shows relative risk and return levels for the fund and some
benchmark, such as Treasury bills or a market index such as the S&P
500. Another method is a bar graph that shows consistency of returns
for the fund and a market index (as measured by monthly rates of return
over the life of the fund). Finally, some fund families use pictures to
show the relative risks of the various funds within the family.
The SEC believes that quantitative measures, graphs, tables, and
other pictorial representations may assist investors in understanding
and comparing funds. The SEC currently requires disclosure of
quantitative information in tabular form in the areas of fund
performance and expenses.18 Recently, the SEC adopted rules that
require graphic depictions of information to facilitate investor
understanding of fund performance.19 The SEC now requests comment
on the relative merits and usefulness of various formats for investment
company risk disclosure, including quantitative measures, graphs,
tables, and other pictorial representations. To what extent should
these methods be used to supplement, or replace, current narrative risk
disclosure?
\18\For mutual funds, see Form N-1A, Items 2 (Synopsis), 3
(Condensed Financial Information), and 5A (Management's Discussion
of Fund Performance). For closed-end funds, see Form N-2, Items 3
(Fee Table and Synopsis) and 4 (Financial Highlights). See also
supra note 1 and accompanying text. A closed-end fund is also
required to include in its prospectus a table quantifying the
effects of leverage on returns to investors. Form N-2, Item
8.3.b.(3) (General Description of the Registrant, Risk Factors,
Effects of Leverage).
\19\See supra note 1. The SEC also recently adopted rules
requiring graphic depictions of issuer performance by public
companies that are not investment companies. Executive Compensation
Disclosure, Securities Exchange Act Rel. No. 31327 (Oct. 16, 1992)
[57 FR 48126 (Oct. 21, 1992)].
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III. Quantitative Measures of Risk
A. Specific Historical Quantitative Measures of Risk and Risk-Adjusted
Performance
This section of the Release discusses several historical
quantitative measures of risk and risk-adjusted performance that could
be used for fund disclosure, and the following section raises a number
of general questions about quantitative measures. Comments are
requested regarding whether the SEC should require fund disclosure of
any one or a combination of the enumerated measures or any other
measures. Persons submitting comments are also asked to consider each
of the enumerated quantitative measures, and any other measures they
may wish to suggest, in the context of the general questions raised in
the following section.
Historical measures of risk and risk-adjusted performance are
generally calculated from past portfolio returns and, in some cases,
past market returns. There are two broad classes of historical risk
measures, referred to in this Release as total risk measures and market
risk measures. In addition, there is a third class of measures, risk-
adjusted measures of performance. (Unless the context indicates
otherwise, risk-adjusted measures of performance are included in
``quantitative risk measures'' and similar terms and phrases used in
this Release.) These three classes of measures are described below, and
examples of each are provided. Comments are requested on the relative
advantages and disadvantages of the three classes of measures and of
specific measures within each class.
1. Measures of Total Risk
Total risk measures, including standard deviation and semi-
variance, quantify the total variability of a portfolio's returns
around, or below, its average return.
Standard Deviation of Total Return. The risk associated
with a portfolio can be viewed as the volatility of its returns,
measured by the standard deviation of those returns.20 For
example, a fund's [[Page 17175]] historical risk could be measured by
computing the standard deviation of its monthly total returns over some
prior period, such as the past three years. The larger the standard
deviation of monthly total returns, the more volatile, i.e., spread out
around the fund's average monthly total return, the fund's monthly
total returns have been over the prior period. Standard deviation of
total return can be calculated for funds with different objectives,
ranging from equity funds to fixed income funds to balanced funds, and
can be measured over different time frames. For example, a fund could
calculate standard deviation of monthly returns over the prior three
years or yearly returns over the prior ten years.
\20\William F. Sharpe, Gordon J. Alexander, and Jeffery V.
Bailey, Investments 178 (5th ed. 1995) [hereinafter ``Sharpe,
Alexander, & Bailey'']. If the returns earned by a portfolio are
``normally'' distributed, that is, in the shape of a bell curve,
approximately 95% of the actual returns will fall within two
standard deviations of the average return. Random Walk, supra note
7, at 219. For example, for a fund with an average monthly return of
1% and a standard deviation of 4%, 95% of the fund's monthly returns
would fall between -7% (1%-(2 x 4%)) and 9% (1%+(2 x 4%)) if the
returns were ``normally'' distributed. See Sharpe, Alexander, &
Bailey, supra, at 177.
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Semi-variance. Standard deviation measures both ``good''
and ``bad'' outcomes, i.e., the variability of returns both above and
below the average return. To the individual investor, however, risk may
be synonymous with ``bad'' outcomes.21 Semi-variance, which can be
used to measure the variability of returns below the average return,
reflects this view of risk.22 A fund with a larger semi-variance
has returns that are more spread out below the average return.
\21\See Sharpe, Alexander, & Bailey, supra note 20, at 178;
Allan Flader, ``Deviating from the Standard,'' Financial Planning,
June 1994, at 148.
\22\Funds' risk levels would be ranked in the same order using
semi-variance and standard deviation if the distribution of fund
returns were symmetric. Sharpe, Alexander, & Bailey, supra note 20,
at 178.
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2. Measures of Market Risk
Individual securities, and portfolios of securities, are generally
subject to two sources of risk: (i) Risk attributable to firm-specific
factors, including research and development, marketing, and quality of
management; and (ii) risk attributable to general economic conditions,
including the inflation rate, interest rates, and exchange
rates.23 According to academic literature in Finance, firm-
specific risk can be reduced or eliminated through portfolio
diversification, but the risk attributable to general economic
conditions, so-called ``market risk,'' cannot be eliminated through
diversification.24 Unlike standard deviation and variance, which
measure portfolio risk from both sources, the measures described in
this section are measures of market risk. The SEC requests comment on
whether, given that most fund portfolios are diversified, it is
appropriate to focus on market risk when measuring fund risks.
\23\Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments 197
(2d ed. 1993) [hereinafter ``Bodie, Kane, & Marcus''].
\24\Bodie, Kane, & Marcus, supra note 23, at 197-99; Sharpe,
Alexander, & Bailey, supra note 20, at 212-17.
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Beta. Beta measures the sensitivity of a security's, or
portfolio's, return to the market's return. The market's beta is by
definition equal to 1. Portfolios with betas greater than 1 are more
volatile than the market, and portfolios with betas less than 1 are
less volatile than the market. For example, if a portfolio has a beta
of 2, a 10% market return would result in a 20% portfolio return, and a
10% market loss would result in a 20% portfolio loss (excluding the
effects of any firm-specific risk that has not been eliminated through
diversification).25
\25\Sharpe, Alexander, & Bailey, supra note 20, at 211; Frank J.
Fabozzi and Franco Modigliani, Capital Markets: Institutions and
Instruments 136-40 (1992) [hereinafter ``Fabozzi & Modigliani''].
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The calculation of a fund's historical beta requires the selection
of a benchmark market index, and persons supporting the use of beta are
asked to address how the benchmark should be selected and whether a
single benchmark should be used for all funds. If a single benchmark
should be selected, what should it be? If a single benchmark is not
used, how should the lack of comparability of betas for funds using
different benchmarks be addressed? Beta is generally used in connection
with equity securities, and persons submitting comments are asked to
address whether or not the use of beta should be limited to equity
funds.
Duration.26 Duration is a measure of the price
sensitivity of a bond, or bond portfolio, to interest rate
changes.27 There are different types of duration,28 and
persons supporting the use of duration are asked to be specific
regarding the duration measure that they support. Would so-called
``modified duration,'' which can be interpreted as the percentage
change in the price of a bond, or bond portfolio, for a 100 basis point
change in yield, be particularly useful?29
\26\The SEC previously requested comment on duration as a
measure of interest rate risk for securities held by money market
funds. See Rel. 19959, supra note 15, Sec. II.D.2.d., 58 FR at
68602. In response to that request, several persons submitting
comments expressed support for the use of duration or other price
volatility tests; one person specifically opposed a duration
requirement on the grounds that the costs funds would incur would
outweigh benefits to investors. See Summary of Comment Letters on
Proposed Amendments to Rules Regulating Money Market Funds Made in
Response to Investment Company Act Rel. 19959, File No. S7-34-93,
Nov. 10, 1994, at 63-64.
\27\Bodie, Kane, & Marcus, supra note 23, at 473-74. Duration
measures the weighted average maturity of a bond's, or bond
portfolio's, cash flows, i.e., principal and interest payments. A
zero-coupon bond's duration, for example, is the same as its
maturity because its sole cash flow is the payment made at maturity.
By contrast, a bond bearing interest payable periodically has a
duration that is shorter than its maturity because the periodic
interest payments reduce the weighted average maturity of the bond's
cash flows below the final maturity of the bond. Id.
\28\For a discussion of the computation and interpretation of
so-called ``Macaulay duration'' and ``modified duration,'' see
Bodie, Kane, & Marcus, supra note 23, at 473-75, and Fabozzi &
Modigliani, supra note 25, at 393-98.
\29\Fabozzi & Modigliani, supra note 25, at 397. For example, if
a bond portfolio has a modified duration of 7 and yield increases by
100 basis points, the estimated decrease in the value of the
portfolio would be 7%.
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The use of duration has several limitations, and persons submitting
comments are asked to address each of these. First, duration is only
meaningful for bonds and portfolios of bonds and therefore cannot be
used to measure the risk of equity funds and has limited applicability
to balanced funds. Second, duration measures interest rate risk only
and not other risks to which bonds are subject, e.g., credit risks and,
in the case of non-dollar denominated bonds, currency risks. Third,
duration is difficult to calculate precisely for bonds with prepayment
options, e.g., mortgage-backed securities, because the calculation
requires assumptions about prepayment rates.30 Fourth, bond value
changes resulting from interest rate changes are sometimes poorly
predicted by duration.31
\30\See James Hom and Gary Arne, Standard & Poor's,
``Prepayments and Model Error in Fund Risk Ratings,'' CreditReview,
Jan. 16, 1995, at 17-18; John Rekenthaler, Commentary: ``Duration
Arrives,'' Morningstar Mutual Funds, Jan. 21, 1994, at 1-2.
\31\Duration is less useful as a measure of interest rate risk
when the following conditions are not met: (1) the yield curve is
flat (i.e., interest rates for all maturities of bonds are the
same), (2) changes in yield are small, and (3) yield shifts are
parallel (i.e., the Treasury yields of all maturities change by
equal numbers of basis points). See Fabozzi & Modigliani, supra note
25, at 396-401.
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The SEC staff takes the position that, for a fund with a name or
investment objective that refers to the maturity of the fund's
portfolio, such as ``short-term'' or ``long-term,'' the dollar-weighted
average portfolio maturity of the portfolio must reflect that
characterization.32 The SEC requests [[Page 17176]] comment on
whether, separate and apart from duration's potential use as a
quantitative risk measure, a fund's name or investment objective that
refers to the maturity of its portfolio should be required to be
consistent with the fund's duration.
\32\See, e.g., Form N-7 for Registration of Unit Investment
Trusts Under the Securities Act of 1933 and the Investment Company
Act of 1940, Investment Company Act Rel. No. 15612 (Mar. 9, 1987)
[52 FR 8268, 8301 (Mar. 17, 1987)] (guide to proposed registration
form for unit investment trusts publishing staff position on
portfolio maturity).
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3. Risk-Adjusted Measures of Performance33
\33\The SEC has solicited comment on risk-adjusted measures of
performance on two prior occasions. In 1990, the SEC requested
comment on whether mutual funds should be required to adjust
performance figures to reflect risk for purposes of Item 5A of Form
N-1A. See Disclosure and Analysis of Mutual Fund Performance
Information; Portfolio Manager Disclosure, Investment Company Act
Rel. No. 17294 (Jan. 8, 1990) [55 FR 1460, 1464 (Jan. 16, 1990)].
See also Summary of Comments on Proposed Amendments to Form N-1A,
File S7-1-90, at 23-24 (summarizing views of the nine persons
submitting comments who addressed risk adjustment of performance,
all of whom opposed it).
In 1986, the SEC requested comment on how mutual funds could
present risk-adjusted performance information in advertisements
prepared in accordance with rule 482 under the Securities Act of
1933 [17 CFR 230.482]. See Advertising by Investment Companies;
Proposed Rules and Amendments to Rules, Forms, and Guidelines,
Investment Company Act Rel. No. 15315 (Sept. 17, 1986) [51 FR 34384,
34390 (Sept. 26, 1986)]. See also Summary of Comments on Mutual Fund
Advertising Proposals, File No. S7-23-86, Mar. 31, 1987, at 69-70
(summarizing views of the thirteen persons submitting comments who
addressed the issue, including nine who supported it and one who
opposed it).
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Risk-adjusted measures of performance were developed in the 1960s
to compare the quality of investment management. Three widely-used
risk-adjusted measures are:
Sharpe Ratio.34 Also known as the Reward-to-
Variability Ratio, this is the ratio of a fund's average return in
excess of the risk-free rate of return (``average excess
return'')35 to the standard deviation of the fund's excess
returns. It measures the returns earned in excess of those that could
have been earned on a riskless investment per unit of total risk
assumed.
\34\See William F. Sharpe, ``The Sharpe Ratio,'' 21 Journal of
Portfolio Management 49-58 (Fall 1994); William F. Sharpe, ``Mutual
Fund Performance,'' 39 Journal of Business 119-38 (Jan. 1966);
Sharpe, Alexander, & Bailey, supra note 20, at 935-37; Edwin J.
Elton & Martin J. Gruber, Modern Portfolio Theory and Investment
Analysis 648-52 (4th ed. 1991) [hereinafter ``Elton & Gruber''].
\35\The yield on 90-day Treasury bills is often used as a proxy
for the risk-free rate of return.
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Treynor Ratio.36 Also known as the Reward-to-
Volatility Ratio, this is the ratio of a fund's average excess return
to the fund's beta. It measures the returns earned in excess of those
that could have been earned on a riskless investment per unit of market
risk assumed. Unlike the Sharpe Ratio, the Treynor Ratio uses market
risk (beta), rather than total risk (standard deviation), as the
measure of risk.
\36\See Jack L. Treynor, ``How to Rate Management of Investment
Funds,'' 43 Harvard Business Review 63-75 (Jan.-Feb. 1965); Sharpe,
Alexander, & Bailey, supra note 20, at 934-35; Elton & Gruber, supra
note 34, at 657-58.
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Jensen's Alpha.37 This is the difference between a
fund's actual returns and those that could have been earned on a
benchmark portfolio with the same amount of market risk, i.e., the same
beta, as the portfolio.38 Jensen's Alpha measures the ability of
active management to increase returns above those that are purely a
reward for bearing market risk.
\37\Michael C. Jensen, ``The Performance of Mutual Funds in the
Period 1945-1964,'' 23 Journal of Finance 389-416 (May 1968);
Michael C. Jensen, ``Risk, the Pricing of Capital Assets, and the
Evaluation of Investment Portfolios,'' Journal of Business (Apr.
1969); Sharpe, Alexander, & Bailey, supra note 20, at 927-34.
\38\For an equity fund, the benchmark portfolio could be
comprised of a market index, e.g., the S&P 500, and a risk-free
asset, e.g., 90-day Treasury bills. Sharpe, Alexander, & Bailey,
supra note 20, at 798.
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B. General Issues
This section of the Release raises a number of general questions
about quantitative risk measures. Persons submitting comments are asked
to address these questions, particularly in the context of specific
quantitative measures.
1. Benefits of Quantitative Risk Measures
The SEC asks for comments on the potential benefits that could be
derived from fund disclosure of quantitative risk measures. Comments
are also requested on associated costs and burdens.
Would quantitative risk measures, including risk-adjusted measures
of performance, help investors to evaluate historical performance and
investment management expertise? The SEC requires that fund
prospectuses include standardized return information,39 even
though past returns are not necessarily indicative of future returns.
Persons submitting comments are asked to address whether quantitative
disclosure of the risk level incurred to produce stated returns may
provide investors with a better tool to understand past fund
performance and management.40 Historical data could, for example,
help investors distinguish among funds that have achieved comparable
rates of return with significantly different levels of risk. Would it
be helpful to investors for funds to present one or more risk measures
together with fund performance data in the financial highlights
table?41 Would a risk measure that covers the same periods
currently required for reporting total returns in the financial
highlights table in fund prospectuses or in mutual fund advertisements
be useful to investors?42
\39\Form N-1A, Item 3; Form N-2, Item 4.
\40\For discussions of the importance of risk as a component of
performance evaluation, see Sharpe, Alexander, & Bailey, supra note
20, at 917-49, and Bodie, Kane, & Marcus, supra note 23, at 796-826.
Funds are currently required to disclose historical returns for
each of the last ten fiscal years (or, if less, the life of the
fund). See Form N-1A, Item 3. This data shows variability of past
annual returns and therefore provides some guidance regarding past
risk.
\41\See Form N-1A, Item 3; Form N-2, Item 4 (financial
highlights table).
\42\See Form N-1A, Item 3 & Form N-2, Item 4 (fund financial
highlights tables cover each of last ten fiscal years); rule 34b-1
under the Investment Company Act [17 CFR 270.34b-1] & rule 482(e)(3)
under the Securities Act [17 CFR 230.482(e)(3)] (non-money market
mutual fund advertisements and sales literature containing
performance information required to contain average annual total
return for one, five, and ten years).
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Would quantitative risk measures be useful to investors as
indicators or guides to future fund risk levels, enhancing investors'
ability to compare risks assumed by investing in different funds? The
SEC requests any research related to the degree of correlation between
historical measures of a fund's risk and expected future levels of
risk.
2. Risk Measures Currently Used by Investment Companies
The SEC requests comment on whether quantitative risk measures that
are currently used by investment companies for internal purposes, such
as portfolio management, evaluation or compensation of portfolio
managers, and reports by management to the board of directors, could be
adapted for disclosure purposes. This approach could have two potential
advantages: first, the measures currently used by investment companies
presumably have been determined to be the most useful by fund managers,
who are in the best position to understand and analyze fund risk; and,
second, use of these measures for disclosure purposes should impose
relatively small additional costs on funds. The SEC therefore requests
that persons submitting comments identify which quantitative risk
measures funds use internally and for what purposes.
The SEC also asks persons submitting comments to discuss the extent
to which quantitative risk measures used by investment companies for
internal purposes would be useful to investors. If such measures would
not be useful to investors, why not? How might internal measures be
adapted to avoid or overcome these problems?
3. Investor Understanding of Quantitative Risk Measures
Persons submitting comments are asked to discuss the difficulties
that [[Page 17177]] investors would face in properly interpreting
various quantitative risk measures, such as understanding what aspects
of risk are measured, the limits on predictive utility of risk
measures, and the importance of investment time horizon in determining
how much risk to assume. Are the difficulties significantly greater
than those associated with the proper interpretation of yield and
return figures? Is there a potential problem of investor over-reliance
on quantitative risk measures, and, if so, what could be done to
protect against such over-reliance?
Comments are also requested regarding which quantitative risk
measures would be easiest for investors to use properly and how
quantitative measures can be made more understandable to investors. One
possibility is to provide some form of interpretation of raw numbers.
For example, standard deviations could be divided by the standard
deviation for some benchmark such as the S&P 500. Another possibility
is to convert raw numbers into a classification scale, such as one to
ten or ``very low'' to ``very high'' risk. Another possibility would be
to represent the level of fund volatility graphically, rather than
through computation of standard deviation. Would it be helpful, for
example, if funds were required to include a bar graph showing total
returns for each of the last 10 years to provide investors a picture of
the extent to which annual returns varied over that period and the
frequency with which the returns were negative or below some benchmark?
Would a chart like the following be helpful?
Using historical numbers, the following illustrates the fund's
estimated variability of quarterly returns over the noted periods
(i.e., approximately 95% of the time, the fund's quarterly returns fell
within these ranges).
------------------------------------------------------------------------
10 year 5-year 3-year
------------------------------------------------------------------------
-5% to 9%............... -4% to 8%............... -5% to 8%.
------------------------------------------------------------------------
Are there narrative disclosures that can help investors to
understand risk measures? Persons submitting comments are asked to
report the results of any experience with, or research on, the relative
effectiveness of alternative means of presenting quantitative
information.
4. Historical Measures v. Portfolio-Based Measures v. Risk Objectives
or Targets
There are three approaches to the use of quantitative risk
measures: historical, portfolio-based, and risk objectives or targets.
The SEC asks for comments on the relative merits and limitations of
these three approaches.
The simple historical approach to quantitative risk measures is
outlined in section III.A., above. This method generally uses actual
past returns of a fund to compute a measure of risk for the fund. An
alternative is a portfolio-based computation, which calculates a
portfolio risk measure based on the particular securities in the
portfolio as of a specified measurement date.43 This method, too,
is historical in that the computation (i) uses the portfolio
composition as of a specified measurement date, and (ii) the
computation is based on historical behavior of the securities in the
portfolio.
\43\See, e.g., Comptroller of the Currency, Risk Management of
Financial Derivatives 49-53 (Oct. 1994); J.P. Morgan, Introduction
to RiskMetricsTM (2d ed.) (Oct. 25, 1994); Group of Thirty,
Derivatives: Practices and Principles 10-11 (July 1993).
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There are at least two important limitations of using portfolio-
based measures for fund disclosure: first, a fund may be invested in
newly introduced financial instruments that have little or no history,
and for which historical behavior must be estimated, and, second,
portfolio-based measures, which are derived from portfolio composition
on one particular date, may be less representative of the risk of a
managed portfolio over time than a simple historical measure derived
from fund returns over a period of time.
The SEC seeks comment on whether the SEC should require funds
generally to disclose portfolio-based risk measures.44 The SEC
also asks for comments on whether such measures could be useful for new
funds that do not have sufficient operating history to make use of a
simple historical measure meaningful, funds that change their
investment objectives or policies, funds that change investment
advisers or portfolio managers, or merged funds comprised of different
funds with different operating histories and different past risk
levels.45
\44\The Investment Company Institute has suggested that
portfolio-based measures would be of limited relevance at best in an
actively managed portfolio, would ignore the role of portfolio
management, and would be burdensome to compute. ICI Letter, supra
note 12, at 8 n.10.
\45\Issues have arisen with respect to fund advertisement of
performance information in similar circumstances. See IDS Financial
Corp. (pub. avail. Dec. 19, 1994) (acquisition of other funds'
assets); North American Security Trust (pub. avail. Aug. 5, 1994)
(combination of two funds); The Managers Core Trust (pub. avail.
Jan. 28, 1993) (newly formed hub fund); Unified Funds (pub. avail.
Apr. 23, 1991) (changed investment adviser); John Hancock Asset
Allocation Trust (pub. avail. Jan. 3, 1991) (change from money
market fund to asset allocation fund); Founders Funds, Inc. (pub.
avail. Oct. 15, 1990) (change from unit investment trust to mutual
fund); Zweig Series Trust (pub. avail. Jan. 10, 1990) (changed
investment adviser); Philadelphia Fund, Inc. (pub. avail. Oct. 17,
1989) (changed investment adviser); Commonwealth Funds (pub. avail.
June 14, 1989) (combination of two funds); Investment Trust of
Boston Funds (pub. avail. Apr. 13, 1989) (changed investment
adviser); The Fairmont Fund Trust (pub. avail. Dec. 9, 1988)
(changed investment objective); and Growth Stock Outlook Trust, Inc.
(pub. avail. Apr. 15, 1986) (new fund).
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Another approach to risk measures is requiring funds to announce
risk objectives or targets. Any of the risk and risk-adjusted
performance measures could be used by funds in this manner. For
example, a fund could announce its intention to follow a strategy that
would yield a standard deviation of 10%-12% per year, a beta of 1.50-
1.75 with respect to the S&P 500, or a duration of 7-9 years. Comments
are requested regarding the relative merits of this approach as
compared to the simple historical and portfolio-based approaches.
Persons submitting comments are asked to address specifically the
relative merits for funds with significant operating histories, new
funds, funds that change their investment objectives or policies, funds
that change investment advisers or portfolio managers, or merged funds
comprised of different funds with different operating histories and
different past risk levels. Persons supporting the use of simple
historical measures by relatively new funds, funds that change their
investment objectives or policies or their investment advisers or
portfolio managers, or merged funds are also asked to address whether
narrative disclosure should be required to explain the limits on the
usefulness of the disclosure resulting from the funds' circumstances.
5. Computation Issues
Comments are requested on the following issues related to
computation of quantitative risk measures and on any other relevant
computation issues. What length of fund operating history is required
to make particular historical risk measures useful? What requirements
should be imposed on funds without this operating history? For example,
if 18 months of operations are required to calculate a meaningful
standard deviation figure, should funds that have been operating for
less than 18 months be required to disclose the standard deviation of
an appropriate market index or peer group of funds and explain any
differences they expect between the fund's standard deviation and that
of the index or peer group? [[Page 17178]]
For risk measures that require the use of a benchmark market index,
what issues, if any, are associated with the selection of an
appropriate benchmark? How should the SEC address the need to use
assumptions to calculate certain risk measures, such as the prepayment
assumptions that may be required to calculate duration? Can various
quantitative risk measures be manipulated and how do the various
measures differ in their susceptibility to manipulation? How can the
potential for such manipulation be reduced or eliminated? For instance,
is there some combination of risk measures the SEC could require that
would not be susceptible to simultaneous manipulation?
Persons submitting comments are also asked to describe as
specifically as possible the computation method they would recommend
for any quantitative risk measure they favor. For example, persons
favoring standard deviation should specify whether monthly returns,
quarterly returns, or returns over some other periods should be used.
As another example, persons favoring beta should describe the benchmark
or benchmarks that should be used. Persons submitting comments are also
asked to discuss the benefits and limitations associated with their
recommended method of computation.
6. Effects on Portfolio Management
The SEC recognizes that requiring disclosure of a quantitative risk
measure may affect portfolio management, e.g., causing fund managers to
adopt more conservative investment strategies. Comments are requested
regarding whether, and how, disclosure of a quantitative risk measure
might influence portfolio management and evaluating the associated
benefits and detriments.
7. Third Party Providers of Quantitative Risk Information
The financial press and other third parties currently disseminate
some quantitative information regarding fund risks. The available
information includes measures such as those described in section
III.A., including standard deviation, beta, and duration.46 In
addition, some organizations disseminate fund performance ratings that
take risk into account47 or fund risk ratings.48 This data is
made available either through reports and other documents published by
the organizations that collect and calculate the measures or through
periodicals and newspapers covering financial issues.
\46\See, e.g., CDA/Wiesenberger, Mutual Funds Update, Dec. 31,
1994; Morningstar Mutual Funds, Dec. 9, 1994; The Value Line Mutual
Fund Survey, Part 2, Ratings & Reports, Feb. 21, 1995. Value Line
also ranks mutual funds in five risk categories, based on historical
standard deviation. How to Use The Value Line Mutual Fund Survey, A
Subscriber's Guide (1994), at 4-5.
\47\See, e.g., Business Week, Feb. 14, 1994, at 78-79; Forbes,
Aug. 29, 1994, at 174; CDA/Wiesenberger, Investment Companies
Yearbook 1994 441 (1994); Morningstar Mutual Fund Performance
Report, Jan. 1995, at 3; How to Use The Value Line Mutual Fund
Survey, A Subscriber's Guide (1994), at 4-5.
\48\These ratings are based on an analysis of factors such as
currency, interest rate, liquidity, and mortgage prepayment risks;
hedging; leverage; and the use of derivatives. See ``Bond Fund Risks
Revealed,'' Fitch Research Special Report, Oct. 17, 1994, at 1; Gary
Arne, Standard & Poor's, CreditReview, Jan. 16, 1995, at 12.
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The SEC asks persons submitting comments to address the SEC's role
with respect to disclosure of quantitative risk information in light of
the availability of fund risk information from the financial press and
other third parties. Is there, for example, helpful risk information
that third party providers do not make available? Would SEC-required
disclosure be important to ensure that all investors have access to
some quantitative risk information and to help educate investors about
the importance of such information? Would SEC-required disclosure be
important to facilitate comparability among funds by ensuring that
standardized quantitative risk information will be available for all
funds? Would SEC-required disclosure of a quantitative risk measure be
helpful wherever historic returns are reported to indicate to investors
the risks incurred to generate those returns?
Persons submitting comments are also asked to address whether the
SEC should take any steps to facilitate the provision of fund risk
information by the financial press and other third parties. For
example, should the SEC require more frequent disclosure of fund
portfolio holdings or more detailed descriptions of fund portfolio
holdings to facilitate third party risk analyses? If so, what
information should the SEC require funds to make available and with
what frequency? The SEC is currently authorized to require funds to
file with the SEC ``such information * * * as the SEC may require, on a
semi-annual or quarterly basis, to keep reasonably current the
information and documents contained in the [funds' Investment Company
Act of 1940] registration statement[s] * * *.''49 Persons
submitting comments are asked to address whether statutory amendments
would be required to implement any recommendations they make in
response to this paragraph.
\49\Investment Company Act Sec. 30(b) [15 U.S.C. 80a-29(b)].
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Last year, the SEC requested comment regarding whether it should
encourage or require disclosure of third party fund risk ratings in
prospectuses, sales literature, and advertisements.50 Persons who
wish to address that issue in the context of today's broad inquiry into
improved risk disclosure are invited to do so.
\50\Nationally Recognized Statistical Rating Organizations,
Securities Act Rel. No. 7085 (Aug. 31, 1994) [59 FR 46314 (Sept. 7,
1994)]. The SEC is currently studying the comment letters received.
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IV. Narrative Disclosure Options
The SEC asks for comment on the usefulness to investors of
narrative risk disclosure currently found in prospectuses.51 The
SEC also asks persons submitting comments to describe ways of improving
narrative risk disclosure that will not increase, and may reduce,
technical information that may be of limited utility to investors. For
example, should prospectus disclosure focus on the broad investment
strategies of a fund rather than the particular investments used to
implement the strategy?
\51\See discussion supra notes 3-5 and accompanying text.
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Can disclosure of fund risks be improved through increased focus on
the policies and investments actually used by a fund as opposed to all
permissible policies and investments? For example, should a fund
describe the policies and investments that have been used during some
prior period, such as the preceding year, or that the fund intends to
use during some future period, such as the following year, and simply
list the other permitted policies and investments? Or should funds be
required to provide a table or grid that indicates whether, and the
extent to which, the policies and investments authorized to be used
were used during some prior period, such as the preceding year? If a
fund intends to alter the mix of policies and investments, should it be
required to describe the projected change? In addressing the questions
of this paragraph, persons submitting comments should consider the
possibilities of placing various information in the prospectus,52
annual [[Page 17179]] report, and statement of additional information.
For example, should the prospectus focus on the policies and
investments the fund has actually made and that it may make in the
reasonably foreseeable future, with the complete list of permissible
investments and policies to be disclosed in the statement of additional
information? As another example, should periodic reports be enhanced to
include more information about what policies and investments the fund
has, in fact, pursued and what risks were actually taken?
\52\Mutual funds generally offer their shares on a continuous
basis and, as a result, are required to file periodic ``post-
effective'' amendments to their registration statements in order to
maintain a ``current'' prospectus required by section 10(a)(3) of
the Securities Act [15 U.S.C. 77j(a)(3)]. Post-effective amendments
also satisfy the requirement that mutual funds amend their
Investment Company Act registration statements annually [17 CFR
270.8b-16]. Because closed-end funds do not generally offer their
shares to the public on a continuous basis, they generally do not
update their prospectuses periodically.
---------------------------------------------------------------------------
Can risks be accurately depicted through narrative disclosure apart
from technical descriptions of particular types of investments? Would
investors find it useful for funds to provide in their prospectuses a
summary of the risk characteristics of the portfolio as a whole either
in lieu of or in addition to disclosure of the characteristics of
particular types of permissible investments? If a risk summary would be
useful, what risks should it address? For example, should the SEC
require a fund that invests a specified level, e.g., 5% or 10% or 25%,
of its net assets in a particular manner, e.g., securities of non-U.S.
companies, to discuss the related risks, e.g., exchange rate
fluctuations?53
\53\Cf. Form N-1A, Item 4(b)(ii) (greater prospectus disclosure
required for investment practices that place more than 5% of a
fund's net assets at risk).
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A mutual fund's Management's Discussion of Fund Performance
(``Management's Discussion''), contained in the prospectus or annual
report, is currently required to discuss the factors, including the
market conditions and the investment techniques and strategies, that
materially affected the fund's performance during the previous fiscal
year.54 The SEC requests comments regarding whether narrative risk
disclosure can be improved through amendments to the requirements for
the Management's Discussion. Should the SEC, for example, explicitly
require the Management's Discussion to address the risks assumed during
the previous fiscal year and the effects of those risks on fund
performance? Should the requirement for the Management's Discussion be
extended to money market funds? If the Management's Discussion is a
useful vehicle for risk disclosure, how should disclosure be
accomplished for closed-end funds, which are not subject to the
Management's Discussion requirements?
\54\Form N-1A, Item 5A.
---------------------------------------------------------------------------
V. Self-Assessment of Risk
Another alternative upon which the SEC seeks comment is self-
assessment by funds of their aggregate risk level. One approach might
be to describe where the fund fits on a risk scale from low risk, for
instance, a money market fund, to moderate risk, for instance, a growth
and income fund investing in S&P 500 stocks and high quality bonds, to
high risk, for instance, an emerging market fund.55 Some fund
complexes currently place various funds within the complex on a risk
scale, and the SEC requests comment on whether such an approach would
be useful for comparing funds from different complexes. If risk self-
assessment is used, should the SEC create a standard scale? Persons
supporting an SEC-created scale are asked to describe specifically what
that scale should be, with particular attention to designing the scale
to promote a high degree of uniformity in funds' self-assessments.
Persons who favor a self-assessment approach but not an SEC-created
scale are asked to address how the approach will foster meaningful
investor comparisons among funds.
\55\In Rel. 19342, supra note 2, the SEC requested comment on
this approach and other formats for disclosing risk, including
numerical scales and other visual or symbolic representations. A
limited number of persons submitting comments addressed these
specific methods for standardizing risk disclosure. Summary of
Comments: Rel. 19342, supra, note 2, at 17-18.
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Comments are also requested on whether funds should be required to
provide self-assessments of their exposures to various types of risk,
with the results presented in chart or table format. Bond funds, for
example, might rate their interest rate risk, credit risk, prepayment
risk, and currency risk on a scale of low to medium to high.
VI. Risk Management Procedures
The disclosure options described in this Release have focused on
improved disclosure of the level of risk incurred by a fund. Persons
submitting comments are also asked to consider whether disclosure of
fund risk management procedures should be required. Such disclosure
could be narrative. For example, should funds be required to disclose
the extent and nature of involvement by the board of directors in the
risk management process? As another example, should funds describe the
``stress-testing'' they do to determine how the portfolio will behave
in various market conditions? Alternately, such disclosure could be
quantitative in format. For example, if the SEC requires disclosure of
a quantitative risk objective or target, funds could be required to
disclose the funds' actual risk level in subsequent periods and compare
it with the previously-provided objective or target and explain the
reasons for divergence.
VII. Liability Issues
Persons submitting comments are asked to address the appropriate
scope of, and limits on, the liability of funds, investment advisers,
and others for various risk disclosures. Persons submitting comments
should specify any forms of risk disclosure that they believe raise
particularly significant liability concerns, explain the concerns, and
suggest means for mitigating the concerns.
VIII. Regulatory Flexibility Act
According to the SEC's rules and unless otherwise defined for a
particular rulemaking proceeding, an investment company with net assets
of $50 million or less at the end of its most recent fiscal year is a
``small entity'' for purposes of the Regulatory Flexibility Act.56
The SEC requests persons submitting comments to describe and project
fund costs to provide the various disclosures described in this
Release, and any other disclosure that persons submitting comments may
wish to discuss, and address whether requiring the disclosure would
have a significant economic impact on small entities. If so, the SEC
asks persons submitting comments to describe that impact specifically.
Persons submitting comments also are asked to suggest methods for
improving disclosure of fund risks without imposing significant costs
on funds, specifically without having a significant economic impact on
funds that are small entities.
\56\Investment Company Act rule 0-10 [17 CFR 270.0-10].
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IX. Conclusion
The SEC is seeking comments and suggestions on a number of specific
issues related to fund disclosure of risks. Persons submitting comments
are encouraged, however, to address any other matters that they believe
merit examination.
Dated: March 29, 1995.
By the Commission.
Margaret H. McFarland,
Deputy Secretary.
Appendix--SEC Request for Investor Suggestions on How To Improve
the Descriptions of Risk in Mutual Funds
The U.S. Securities and Exchange Commission (``the SEC''), the
federal government agency that oversees mutual funds, wants to hear
from investors on [[Page 17180]] how the descriptions of risk in mutual
funds may be improved. When investors choose a mutual fund, they should
understand the risks of the fund before they invest and not be
surprised if the value of their investment rises and falls
significantly.
The risks and potential rewards of investing in any mutual fund are
explained in a written document provided by the mutual fund called a
``prospectus.'' The prospectus contains information that is important
to making an informed decision when choosing a mutual fund.
The SEC is concerned that the descriptions of risk in mutual fund
prospectuses are not as helpful or as clear as they could be. The SEC
is seeking ideas and suggestions on how these descriptions of risk may
be improved. Your ideas and suggestions may shape how risks are
explained in the future and help investors make better investment
choices.
Here are a series of questions and examples on how the descriptions
of risk may be improved. We urge you to respond, whether you answer one
question or all, or just have general comments. Feel free to use this
form or write a separate letter marked ``File No. S7-10-95.''
Please mail your comments to the SEC no later than July 7, 1995.
Directions for sending your comments to the SEC are provided at the end
of this document. The SEC will make your comments and other comments
received by the SEC available to the public.
How do you learn about mutual fund risks? The SEC would like to
know how you learn about the risks of a mutual fund before you invest
in the fund.
Do you learn about mutual fund risks from the fund
prospectus, a broker or bank representative, an investment adviser, a
family member or friend, magazines, newspapers, or other publications?
If you use more than one of these sources, please list all of the
sources that you use.
What information do you find most useful in evaluating
mutual fund risks? What can the SEC do to provide information about the
risks of investing in mutual funds that other sources of information do
not do?
How well do mutual fund prospectuses describe the risks of
investing? The SEC would like to know if you find the way mutual fund
prospectuses describe the risks of investing to be helpful.
Do mutual fund prospectuses give you a good idea of the
risks of investing? What do you like about the way mutual funds
describe risk in their prospectuses and what would you like funds to do
differently?
Would you like all mutual fund prospectuses to contain a
summary of the risks of investing in the fund? If so, what would you
like to see in the summary?
Provide copies of any mutual fund descriptions of risk
that you believe are very helpful or unhelpful. Tell the SEC what you
like or don't like about the descriptions.
What do you want to know about risk? Risk means different things to
different people. The SEC would like to know how you define risk.
Do you define risk as:
(1) the chance that you will lose part of your investment;
(2) the chance that your investment will earn less than a certain
amount, for example, a fixed percentage, such as 5% per year, or the
return on a no-risk investment, such as a bank CD or U.S. treasury
bill, or the return on a stock or bond index, such as the Standard &
Poor's 500 stock index; or
(3) the variability in your fund's return, that is, the month-to-
month or year-to-year ups and downs in your fund's share price or its
distributions?
Or do you define risk in some other way?
In choosing a mutual fund, are you most interested in
comparing the risks of investing in the fund to the risks of putting
your money in:
(1) investments that are not mutual funds, for example, bank CDs or
individual stocks and bonds;
(2) other mutual funds of all types;
(3) mutual funds of the same broad type, for example, stock funds
or bond funds; or
(4) mutual funds with the same investment objective, for example,
short-term bond funds?
Is your need for information about the risks of investing
in mutual funds greater for stock funds or bond funds, or is your need
for information about risk the same in both cases? Explain.
Would you like risk to be described with numbers, graphs, or
tables? The SEC is looking at a variety of ways that mutual funds could
tell investors about risk in addition to, or instead of, descriptions
in words. The SEC would like your ideas and suggestions about which of
those ways would be most helpful to you.
Do you find information most helpful when it is in the
form of written descriptions, numbers, graphs, tables, charts,
pictures, or some other form?
Mutual funds today are required to provide investors with their
annual returns for each of the past 10 years. By looking at these
returns, investors can get an idea of how variable a fund's returns
have been. This variability could be illustrated with a bar graph like
the following.
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Would you find a bar graph like the above helpful in
understanding the ups and downs in a mutual fund's annual returns?
Would it increase your understanding of a fund's risk if the fund also
provided you a bar graph of the returns of a market index, such as the
Standard & Poor's 500 stock index?
The SEC is looking at the possibility of requiring mutual funds to
use numbers to tell investors about the risks of investing. Examples of
the numbers that the SEC is considering as required risk measures are:
Standard Deviation of Total Return. This number measures
how variable a fund's total returns have been, that is, how much they
have gone up and down. The larger the standard deviation, the more
variable a fund's total returns have been.
Duration. This number measures how sensitive a bond fund's
value is to changes in interest rates.
If you have ideas about what risk measurement numbers the SEC
should ask mutual funds to give to investors, the SEC would like to
hear those ideas.
Should the SEC require funds to disclose standard
deviation or duration or any other specific risk measures? Why or why
not?
Should mutual funds rank their risk levels? The SEC is considering
whether it would be useful and practical for mutual funds to rank
various aspects of risk. For example, bond funds could be required to
tell investors whether their exposures to interest rate changes,
default risks, and currency fluctuations are low, medium, or high. This
could be done in the form of a chart like the following.
Risk Summary
------------------------------------------------------------------------
Interest Default
Portfolio rate risk risk Currency risk
------------------------------------------------------------------------
High-Yield Fund.................. Medium.... High...... Low.
Global Bond Fund................. Medium.... Medium.... High.
Mortgage-Backed Security Fund.... High...... Low....... Low.
------------------------------------------------------------------------
Would it be useful for funds to rank various aspects of
risk? Do you find the above chart helpful? Do you understand the types
of risk referred to in the chart and the significance of those risks?
How to mail your ideas and suggestions to the SEC:
This form can be mailed to the SEC by folding it in half,
with the return address showing. Please staple or tape this form
closed. No postage is necessary.
If you do not wish to use this form, you can write a
letter directly to the SEC. Mark your letter ``File No. S7-10-95,'' and
send it to Jonathan G. Katz, Secretary, Securities and Exchange
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.
Remember to send your ideas and suggestions by July 7,
1995.
Do you want further information about what the SEC is considering?
If you would like a copy of the complete SEC release that
describes what the SEC is considering, write to Office of Consumer
Affairs, Securities and Exchange Commission, Attn: Michael Strupp, Mail
Stop 2-6, 450 Fifth Street, N.W., Washington, D.C. 20549.
Thank you for responding.
Your Name--------------------------------------------------------------
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[FR Doc. 95-8143 Filed 4-3-95; 8:45 am]
BILLING CODE 8010-10-P
