Activists, Advisors

Activists, Advisors Press for Better Mutual Funds Disclosure, NAPFA Advisor (Dec. 2000).

If you're bored with the new fall lineup on TV or finding football too tame, here's the perfect solution. Go to the Advocacy page of my website, www.funddemocracy.com, click on the archived broadcast of the Toward Truth in Mutual Fund Investing Symposium, and sit back and enjoy the show.

The Symposium, held in Washington, D.C., on Oct. 12, is the latest chapter in Fund Democracy's broad-reaching campaign to require mutual funds to improve disclosure of their portfolios. Following our lead, since July numerous organizations each have separately petitioned the SEC to adopt rules to improve mutual fund portfolio disclosure, including the Financial Planning Association, ten consumer groups (including the Consumer Federation of American, Consumers Union and Consumer Action), and the National Association of Investors Corporation. The AFL-CIO has announced that it, too, plans to file a petition.

As we learned at the Symposium, the need for more disclosure is great, but major roadblocks remain to implementing a program.

Building the Case for More Frequent Portfolio Disclosure

The Symposium boasted a breadth of views rarely seen at industry conferences. The panel included Paul Roye, director of the SEC's investment management division; Don Phillips, CEO of Morningstar, Inc.; Harold Evensky, chairman of the Evensky Group; Davis Nadig, executive VP and co-founder of MetaMarkets.com (sponsor of the Open Fund); and David Musto, associate professor of finance, Wharton School.

The stage was set for sparks to fly, and the audience wasn't disappointed. Phillips questioned SEC Chairman Arthur Levitt's appreciation of mutual fund investing and charged him with falling "into almost patronizing types of platitudes" when discussing the information that investors need to make informed investment decisions.

"It is simply unconscionable that the information is not available [to investors] about what's being done with their money," added Evensky.

Roye did a bit of an Al Gore in defending his boss by asserting the Levitt "is committed to investor protection." Roye added that Levitt has been responsible for a number of important fund reforms during his tenure, including adopting rules in 1998 that simplified mutual fund prospectuses. But Levitt reportedly remains unconvinced by the case being made for requiring funds to disclose how they are investing their shareholders' money more often than only twice year.

Speaking from the perspective of a financial planner and investment advisor, Evensky reminded Roye that, "It's not the individual stock, it's not the individual funds, it's the portfolio. It's the balance of the various investments that ultimately make the primary difference. In order for me to advise my clients, I need to know where the money is."

The issue is becoming magnified today because so much money in 401(k) plans is being allocated according to computer-based advice, Evensky added. These recommendations rely on fundamental analysis, the quality of which depends on the availability of portfolio information. "The money in 401ks today is likely to be totally misinvested in spite of some of the best brains in the world applying all the latest technologies in making the decisions -- because the information is not there," he charged.

Accountability is another major issue, said Phillips. More frequent portfolio disclosure would "open up an incredible amount of information … [and provide] a real paper trail of who owned what when, so you could go back and study how different managers behave, how they react to different situations, and how active managers add value," he said.

More frequent portfolio disclosure would force managers to be true to their styles or asset classes, which would reduce the problem of investing outside of classes in order to gain a better return. As noted by Phillips, "the easiest way to be number one in your category is to be miscategorized."

Disclosure Will Deter Portfolio Fraud

More frequent portfolio disclosure is to deter window dressing and portfolio pumping. The most common form of window dressing occurs when fund managers buy popular stocks just before disclosure dates in order to impress investors with their stock-picking acumen. But other forms are just as troubling. For example, Musto and his colleagues conducted a study that found that money market funds consistently hold more government securities at the end of their fiscal years, apparently in an attempt to give the appearance of investing more safely. Musto found that window dressing was most prevalent among the worst-performing money market funds, thus suggesting that managers may be adding government securities to their portfolios to make investors believe that their poor performance was due to investing in safer, lower-yielding debt.

Musto's findings regarding portfolio pumping are even more disturbing. Portfolio pumping occurs when fund managers purchase stocks that their funds already hold on the last day of a quarter in order to give their funds' performance a one-day boost. Musto found that equity mutual funds experience their highest returns on the last trading day of the year, and their worst returns on the first trading day of the new year. He believes that this is "something for investors to worry about," as many of them are paying "equity fund prices that are inflated at the end of the quarter."

The SEC has formed a task force "focusing specifically on portfolio pumping and window dressing issues," Roye responded.

The Ontario Securities Commission settled a high-profile portfolio-pumping case against the Royal Bank of Canada's investment management arm in July for C$3 million, and Lori Richards, head of the SEC mutual fund inspections program, told Fund Democracy that she believes that "bringing just one enforcement action in this area would go a long way toward making fund managers think twice before engaging in these kinds of practices."

Mutual Fund Industry Digs In Against Proposals

The mutual funds industry continues to oppose more regular disclosure requirements. One of its favorite arguments is the claim that more frequent disclosure would facilitate front running of, or piggybacking on, fund transactions by traders. While this is a major theoretical concern, Evensky observed that he does not "know of any research that suggests that [piggybacking is] a significant problem for managers."

Nonetheless, disclosure petitioners have proposed to address this potential problem by requiring only monthly disclosure with a 60-day time lag. This would allow a fund at least 90 days to take or liquidate a position, a delay that Phillips believes ensures that "you are not going to have piggybacking."

Another tactic of opponents of the petition has been to exaggerate its proposal - either because they do not understand it, or they seek to discredit the idea. John Brennan, just before he stepped down as chairman of the Investment Company Institute (ICI), recently objected to demands for daily disclosure of mutual fund portfolios, even though no petitioner has asked for more than monthly reporting. ICI President Matt Fink has argued that the disclosure reform proposals will promote "prospectus creep," despite the fact that no petitioner proposed that any additional information be included in the prospectus.

Indeed, in an effort to avoid prospectus creep, petitioners have asked the SEC to require disclosure only on funds' websites. This would dovetail nicely with reducing or eliminating the list of the portfolio securities currently required to be included in reports delivered to shareholders, a reform that the industry historically has supported. The result would be net cost savings for investors because of lower printing and mailing costs, and more information for investors and their advisers.

On the Horizon

In the wake of the multiple petitions and the Symposium, the mutual funds industry may start paying more attention to the portfolio disclosure initiative. I take heart in the way that Roye's comments at the Symposium, while carefully circumscribed, implied general support among SEC staff for portfolio disclosure reform. The earliest that the SEC will be able to propose new rules is probably February or March 2001, which leaves plenty of time for more groups to send a message to the SEC that it's time to hold mutual funds accountable for how they invest their shareholders' money.

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