Speech by SEC Commissioner:
Making Sure Investors Benefit from Money Market Fund Reform
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
Investment Company Institute and Federal Bar Association Mutual Funds and Investment Management Conference
March 15, 2010
Thank you for the kind introduction. It is a pleasure to be here with you at the 2010 Mutual Funds and Investment Management Conference sponsored by the Investment Company Institute and the Federal Bar Association and to have the opportunity to share my views on the challenges and potential reforms facing the industry. At the start, let me issue the standard disclaimer that the views I express today are my own and do not necessarily reflect those of the Commission, the individual Commissioners, or the staff.
As a practitioner in the securities industry for over 30 years, I understand that this time is one of unprecedented challenge. I can not remember a time when such a broad swath of fundamental issues confronted us. For example, at the SEC, we currently find ourselves enmeshed in parallel discussions about the structure of the financial regulatory system, the SEC's role in such a system, and the regulation of entities under our jurisdiction.
However, it is easy to understand why this is so. In the first sentence of his book, Common Sense on Mutual Funds, John Bogle, founder and former chief of executive of Vanguard, wrote “Investing is an act of faith.” I agree with this and it saddens me that as of the book’s 10th year anniversary — in fact, as 2009 ended — he revised that sentence to conclude that “the faith of investors has been betrayed.” The events of the last two years, including the tremendous loss of value experienced by retail investors, have brought to the forefront questions about the integrity of our capital markets, its institutions, and its regulators. While this has created momentum for tremendous change, it is important that the change be oriented toward the needs of investors.
I suspect that much of this year’s conference will be focused on these challenges and the changing regulatory environment. To get the dialogue started, I’ll discuss a proposal that has generated endless discussions and ideas – and that is the creation of a system risk regulator. I’ll explore how this idea, as well as how changes to the SEC, your primary regulator, could impact the regulation of the mutual fund industry. I’ll also discuss recent and proposed changes involving money market funds.
Clearly, there is the possibility of dramatic transformational impact to the industry. It is my fervent hope that it’s done in a smart, measured way, one that doesn’t throw the baby out with the bath water.
Systemic Risk Regulator
A widely discussed aspect of regulatory reform concerns the need to monitor and manage systemic risk. This conversation generally revolves around what to do about companies that are “too big to fail.” As I’ve said repeatedly, I don’t think this should be the dominant goal. Instead, it is my hope that we can shift the dialogue from the discussion of how best to preserve "too big to fail" financial institutions to what is best for investors, particularly retail investors, and to our long-term economic growth. It's important that the focus on "too big to fail" doesn't ignore retail investors by thinking of them as "too small to matter."
I bring this up at this Conference because this systemic risk regulator could have wide-ranging ramifications for the mutual fund industry and the evolution of the industry. It is a development the mutual fund industry needs to closely monitor. The systemic risk discussion is already influencing debate over money market reform. If the industry is defined as one presenting systemic risk, what will that entail? What does it mean for institutions that funds invest in? One view of systemic risk is that government must preserve the viability of institutions that are "too big to fail." But this view can result in a financial regulatory model that focuses too much on specific institutions, not investors. In this system, a government regulator would pick winners and losers among companies at the expense of investors and at the expense of market certainty — as we saw during the events of September 2008.
In addition to defining systemic risk, there is a question as to who will be the systemic risk regulator. In the legislation that was approved in the House of Representatives, those powers were bestowed on the Fed. However, there are those that oppose having the Fed in this role. Clearly, there are inherent tensions and conflicts that arise when one regulator has combined responsibility over monetary policy, a vested interest in the safety and soundness of particular institutions, and plenary powers to address systemic risk. Any organization with a narrow focus on a particular industry and very broad powers is likely to favor that sector to the potential detriment of others. Others, including myself, have suggested a council of regulators that would avoid these tensions and ensure a complimentary relationship between the primary regulator and the systemic risk regulator.
As financial reform legislation continues to move, there are serious questions to be answered including: what actual authority the systemic risk regulator should have, whether it will it be an independent agency or have political leadership and how it will implement procedural protections relative to the exercise of its powers. The answers to these questions may very well dictate outcomes in the mutual fund industry. For example, it isn’t hard to envision that a system risk regulator which is bank-centric may want money market funds to be regulated as banks, and/or want them to be required to have some sort of insurance to protect shareholder assets.
The only sure thing that can be said is that what will happen is anyone’s guess. While the House has approved legislation, the Senate has not. The negotiations in the Senate have been difficult, and it was reported last week that bi-partisan efforts have fallen apart. It is expected that Senator Dodd will put forward his own bill today.
Self-Funding of SEC
I suspect that a key to how the mutual fund industry will be regulated in the future may also largely depend on how the SEC is viewed — in particular, whether we are viewed as a robust and effective regulator. To that end, I am also going to discuss the long-term vitality of your primary regulator, the SEC. As I have consistently advocated, the single most transformational act that Congress could do is to allow the SEC to be self-funded. Unlike almost every other financial regulator, the SEC remains without a stable funding stream. Self-funding would enable the SEC to set multi-year budgets and respond promptly to drastically changing markets, while also maintaining appropriate staffing.
To drive my point home, I would like you to think about your own organizations. How many of you have a one year technology, capital investment program? I would imagine the answer is “no one.” Why is this? It is because technology investments and upgrades happen on 3 to 5 year cycles. Imagine operating in an environment of annual apportionment where you never know how much money you will receive or be able to use from year to year — you are imagining the reality the SEC confronts every day. From 2004 through 2008, the SEC’s budget was flat or declining while the capital market grew significantly — both in size and complexity. When I took office in July 2008, I became concerned about our enforcement and inspection teams’ arcane technology and started to ask questions. It became clear to me that the lack of a stable funding mechanism has led to the circumstances where the agency has systems that are tragically anemic. For the most part, we can not budget or plan for multi-year projects.
Moreover, during this same time period, the SEC received greater regulatory mandates, including authority to regulate credit rating agencies without additional resources. Self-funding would provide the Commission the ability to meet the public’s basic expectations.
Since the 1940s, the SEC has led the way in terms of implementing the rules, fostering compliance, and enforcing the mutual fund regulatory regime. I would argue that the credibility of the SEC as a regulator has been a critical factor in developing the trust that investors have had in the industry and in the industry’s tremendous growth. For both the benefit of the industry and investors, it’s important for the SEC to have the resources to keep up with an evolving industry.
I know that the ICI has been a proponent of self-funding for the SEC and that the industry understands that no matter what additional authority the SEC may receive, without appropriate long-term self-funding, the SEC will not be seen as an effective regulator and will risk being just a "paper tiger." As legislation moves forward, I look forward to your continued advocacy for self-funding.
Money Market Funds
Now I would like to focus on money market funds, without question one of the most successful products the industry has ever developed. Today, a money market fund industry that started with one fund in 1971 now has over 750 funds with more than $3 trillion under management.
Money market funds are interwoven into the fabric of the American economy. They are relied on by investors and intermediaries of all kinds. These funds are attractive to retail and institutional investors alike, both small and large. Corporate treasurers, municipal governments, and other institutional investors use money market funds to manage their short-term cash needs. Broker-dealers, trustees, pension funds, and charitable foundations also use money market funds to manage their own assets, as well as their customers’ assets. Moreover, retirees and other individual investors often invest in money market funds as a way to earn a return on short-term cash waiting to be deployed in other investments.
Issuers, in addition to investors, also rely heavily on money market funds. These funds provide a highly efficient conduit between issuers of high quality short-term debt and investors. Money market funds enable the federal government, corporations, municipalities, and other issuers to readily sell their securities in bulk transactions rather than to a multitude of individual investors in separate transactions. Likewise, money market funds provide investors with easy access to high quality investments and minimize transaction costs.
Obviously, the credit crisis has been challenging for money markets and managers and has affected their profitability. Persistent low yields and the out-flows of assets has resulted in various managers either quitting the business, or reducing the number of money market funds through mergers, liquidations or sales. Nonetheless, even in this environment, money market funds remain an integral part of the fabric by which families and companies manage their financial affairs.
Many attribute the popularity of money market funds to their ability to maintain a stable net asset value — typically at a dollar per share. And as you in this room know, the conditions under which funds are able to price shares at a stable value are set forth by the Commission in Rule 2a-7.
Because of the importance of protecting a stable NAV, Rule 2a-7 provides limits on the risk that these funds may take. More specifically, in order for a fund to hold itself out to the public as being a money market fund, the fund must meet a number of “risk-limiting conditions” designed to protect investors and funds from excessive exposure to certain risks, such as credit, currency and interest rate risks.
Following the events of late 2008, however, it was only appropriate that the Commission revisit the safeguards embedded in Rule 2a-7. Accordingly, the Commission considered and recently adopted new requirements designed to increase the resilience of money market funds to market disruptions.
Enhancements to the core protections of 2a-7
It was with investors in mind that I supported the amendments to Rule 2a-7 to strengthen portfolio quality, maturity, and liquidity requirements by limiting the types of investments funds can make, as well as by adopting new requirements, such as the daily and weekly liquidity requirements that a fund hold investments it can readily turn to cash. The amendments went to the heart of how a money market fund is organized, operated, and liquidated. The changes to Rule 2a-7 recognize the integral role these funds play and are designed to fortify and strengthen the entire money market fund framework by making funds more resilient in the face of credit, liquidity, and interest rate risk.
I recognize that these amendments limiting investment choices and risk taking represent a trade-off between making money market funds more resilient investment vehicles and the cost in potential yield that investors can expect. Taken as a whole, however, they strike an appropriate balance.
The new requirements of 2a-7 decrease the likelihood that money market funds will go through a crisis like we experienced in late 2008 — and they will serve to better align the funds’ ability to maintain a net asset value, typically at $1.00 per share, with the expectation of investors that one (1) dollar in means one (1) dollar out. This may be the most important expectation that investors have when they invest in money market funds. It needs to be protected.
Money market funds have been very successful. They have been so successful that the Commission recognized in the mid-1990s, that “investors generally treat money market funds as cash investments.”1 Moreover, the phenomenal success of these funds combined with the fact that until 2008 only one fund had ever “broken the buck,” has reinforced the public perception of the safety of these vehicles.
I understand the serious conflict that investors view money market funds as safe — when, in fact, these funds are not guaranteed. To make sure that investors were clear on this fact, the Commission, in the early nineties, began to require a money market fund prospectus to clearly delineate on its cover, and in its sales literature and advertisements, that “an investment in the fund is not guaranteed or insured by the U.S. government and that there is no assurance that the fund will be able to maintain its stable net asset value.”
However, the federal intervention of 2008 to halt the beginnings of a money market run may have raised public expectations that the federal government will step in if another crisis occurs. As result, investor confusion may be expected. Even though money market funds have had an enviable track record of safety — and even as they are made more resilient — investors in money market funds need to realize that, as with almost any investment, these investments have risk. I encourage the industry to make sure that its marketing efforts, particularly oral representations to investors, underscore that potential risk rather than exacerbate investor confusion.
Potential Further Action
Notwithstanding the substantial reform recently made as to Rule 2a-7, more may be in the works. Besides what may be contained in the pending money market fund report by the President’s Working Group on Financial Markets, the Chairman as well as senior staff at the Commission have telegraphed a desire to see more fundamental structural change in the money market fund industry. In particular, the staff is examining the merits of a floating, mark-to-market NAV for money market funds, rather than the stable one-dollar price. Other ideas under consideration include real-time disclosure of the shadow price; mandatory redemptions-in-kind for large redemptions (such as by institutional investors); a private liquidity facility to provide liquidity to money market funds in times of stress; and a possible "two-tiered" system of money market funds, with a stable NAV only for money market funds subject to greater risk-limiting conditions and possible liquidity facility requirements, among others.
I believe that any consideration of future reforms should be careful not to jeopardize the tremendous value money market funds bring to investors. As the Commission considers further money market reform, I believe two fundamental priorities must be at the forefront of our consideration. The first priority should be to recognize that money market fund investments have historically worked well for all investors, particularly for retail investors. All contemplated proposals should take retail investors into account and make sure that they are able to continue to participate and benefit.
In addition, any further reform should not be so “transformational” that the money market fund is no longer an economically attractive product. Future proposals should be rigorously analyzed to determine the consequences that would result. One consequence no one wants to see is a flight of trillions of dollars to unregistered vehicles that have no regulatory oversight or accountability. As a second round of reform is contemplated, there needs to be serious consideration given to what other reforms should be made regarding unregistered vehicles to insure that there is no regulatory end-run.
As you are aware, the Commission has been, and will continue to be, in an active rule-making mode. I just want to touch on an initiative that we launched last year — the summary prospectus. As you know, the summary prospectus, in contrast to the traditional prospectus, is designed to streamline the “hard copy” delivery of key information and requires that more detailed information be accessible electronically.
I know fund complexes are in the midst of implementing the use of the summary prospectus and I want to encourage your efforts and ask that you report back to us. Please let our staff know what your experience is as you implement this new form. I am most interested in the reaction of retail investors and the usefulness of this short form to them. As I have voiced on numerous occasions, I have concerns about the Commission’s implementation of an electronic delivery model to deliver essential information to investors. The worst consequences have been in the e-proxy context where the number of retail investors plummeted when e-proxy was implemented. This is where it hit home that the Commission needed to take serious strides to actually equate internet access to information with actual delivery of that information. As a result, I am interested in hearing your feedback and encourage you to try and capture investor’s responses so that we can make sure that the summary prospectus is implemented and used to its maximum effect.
Target Date Funds
Another area the Commission will focus on in the near future is target date funds. Much like ETFs, this is a segment of the industry that has experienced explosive growth in the last decade. By the end of the 1990s, the assets in these funds totaled $10 billion. By July 2009, four separate target-date fund series were larger than the entire industry had been a decade before. In fact, by the end of 2009, assets in target date funds registered with the Commission totaled approximately $240 billion.
These are funds primarily marketed to participants in defined-contribution plans. They are designed to be a one-stop solution that bundle various investment strategies within each respective fund. As the target date approaches, these funds are supposed to be designed to become more conservatively invested. In other words, the assumption would be that each target date fund has a glide path by which the fund decreases its equity allocations and shifts toward fixed income as the investor ages.
These funds are distinct from other funds in two noteworthy ways. First, investors are encouraged to choose a target date fund based on the best match with the investor’s retirement date rather than by choosing between funds and conducting their own assessment of risk. Second, target date funds change their investment allocations over time, so theoretically investors may believe that they have no need to monitor or adjust how their investment is allocated.
In 2008, however, some target date funds with very near-term target dates lost substantial amounts of money and these assumptions were called into question. In fact, many investors were shocked by losses of 25-30% in the average short-dated target date fund and almost 40% in the longer-dated funds. There is some concern that the use of particular dates may mask the fact that funds with the same “target date” can differ dramatically in terms of glide path. In order words, no two target date funds are exactly alike, and the variation among series can be dramatic. If investors are only looking at the “target date,” they will most probably fail to assess whether the glide path suits their personal risk objectives.
Given these results, I believe that the Commission should require that investors receive clear disclosure that appropriately lays out the crucial information. Even Morningstar, in its report on target date funds, said it was hard for it to get consistent information on basic glide path allocations, much less more sophisticated data.2 If a professional data service like Morningstar is struggling, I am fearful for investors. Investors must receive disclosure so that they can ascertain how each target date fund is constructed and how it will work.
Moreover, it has been well documented that the language used by firms to market their target date fund series has been “vague and comforting” and “belies the specific and substantial differences within the industry.”3 There is a real concern that advertisements by target funds perpetuate a "set it and forget it" mentality.
I look forward to the staff’s recommendation in this area.
Diversity in the Boardroom
As I near the end of my remarks, I also want to mention a recent Commission rule recognizing the importance to investors of diversity in the boardroom.
Investors have been asking the Commission to require diversity-related disclosures for years. As a part of a recent rulemaking, we were deluged with letters expressing support for disclosure of information related to race and gender. Persons and organizations representing over $3 trillion in assets sent in these letters advising us that information about board diversity is something they find important in their assessment of companies that they own.
In response, the Commission adopted a rule that is an important first step in aiding an investor's ability to assess a company's commitment to developing and maintaining a diverse board.
Specifically, the rule will require a company to disclose
- whether diversity is a factor in considering candidates for nomination to the board of directors,
- how diversity is considered in that process, and
- how the company assesses the effectiveness of its policy for considering diversity.
Beyond the actual disclosure that will be required, I want to encourage the mutual fund industry to prioritize and implement practices to increase corporate board diversity. It is imperative to have processes in place to be able to identify diverse candidates. For example, a mutual fund’s nominating committee should proactively develop a pipeline of diverse candidates in advance of a board opening.
As I sum up my remarks today, I want to reiterate the value that mutual funds and money market funds have to investors and our capital markets and emphasize that any further reform should not undercut that value. These funds are a key part of how investors save for college tuition and set aside funds for retirement — and are integral to our capital markets. The mutual fund industry has a lot to offer in determining how to proceed. Addressing these issues in an intelligent and rational manner is important, and ultimately will result in a stronger and more vibrant industry.
1 61 Fed. Reg. 13955, 13957 (Mar. 28, 1996).
2 Morningstar, Target Date Series Research Paper 2009 Industry Survey, September 9, 2009.