FA Q&A

Articles About Fund Democracy

Regulatory Talk, Fund Action (August 28, 2000)

In this Q&A piece, Mercer Bullard discusses mutual fund regulatory issues, including the need for the SEC to take action against funds that use misleading performance advertisements and misprice their portfolios, and to improve fund portfolio disclosure requirements.

Q: What is your response to the industry argument that giving out more current information about the contents of fund portfolios amounts to tipping off competitors to a fund's investment strategy?

Fund Democracy: Well, the risk that portfolio disclosure can harm fund shareholders is real, albeit greatly exaggerated. If there's evidence that monthly disclosure, with, let's say, a sixty--day delay period, as proposed by Fund Democracy, could tip off the competition, I'd like to see it. If there are cases in which harm is possible, then the Commission can provide exemptions on a case-by-case basis. But the way I see it, the industry essentially is arguing that the SEC should continue to facilitate portfolio fraud, and deprive investors of the information they need to make informed investment decisions, in order to prevent a purely theoretical harm to less than one percent of funds. I disagree.

Q: You have commented that one-year performance reporting can be misleading and yet SEC regulations require it. How best could the SEC deal with one-year results, and have you any other thoughts about what you think ought to be in the guidance on fund ads the SEC is preparing?

Fund Democracy: The SEC should simply jettison the view that tiny font, narrative disclosure in a footnote at the bottom of an ad serves any purpose whatsoever. The SEC needs to take a lesson from fund advertisers, who use one-year results in big print in the middle of the page because that is what catches investors' attention. A good example, I think, is a recent ad for the Internet Fund which shows its 216% return in 1999, its #1 Lipper ranking, along with its 5-star Morningstar rating. Now I would require the ad to show the fund underperformed many Internet stock indices in 1999, and that its 1997 return was only 13%.

As for the Lipper ranking and Morningstar rating, they're both based on thousands of general equity funds. The NASD should prohibit the use of these ratings or require that they be replaced with comparisons to technology or Internet funds. For example, in Morningstar's technology category, the Internet Fund gets an average ranking. It's not number one by a long shot. This kind of ad is extremely misleading, but because of regulatory inaction, you couldn't make that claim stick in court. If the SEC and NASD won't do anything about this, I believe that there are state securities commissions and members of Congress who will.

Q: Could you elaborate on that thought?

Fund Democracy: There are two possibilities. State securities commissioners often are able to take action if they harbor their resources and act in concert because individual securities commissions do not have the resources to bring these cases. They could get together to bring cases, using what's still left of their authority over the securities industry, which is to prosecute fraud.

The alternative would be for members of Congress, who are showing an increasing interest in mutual fund issues, as mutual funds have essentially become retail products owned by almost half of U.S. households, to enact legislation requiring the SEC to adopt rules that would prohibit this kind of fraudulent advertising.

Q: How would you have the SEC further clarify the legal obligations funds have to fair value their shares rather than use an old market price? As a former regulator yourself, what steps would you have them take beyond the most recent SEC action in this area, the Dec. 8, 1999 letter to the industry?

Fund Democracy: Mutual funds that use materially stale prices are costing their shareholders money. What's most frustrating about this is that it's illegal, and the SEC has been unwilling to come out and say so. The staff's December 8 letter doesn't do the job. It will take an express statement by the staff to reverse its longstanding position that funds can, but are not required to, fair value price their portfolios.