The Investment Company Institute
February 23, 2004
Mr. Jonathan G. Katz
Re: Commission Request For Comments on Measures to Improve Disclosure of Mutual Fund Transaction Costs (File No. S7-29-03)
The Investment Company Institute1 appreciates the opportunity to comment on the Securities and Exchange Commission's concept release on issues relating to the disclosure of mutual fund transaction costs2. The Institute strongly supports improving investor awareness and understanding of fund fees and expenses and recognizes the importance of improving disclosure concerning fund transaction costs and their effect on fund performance. We therefore commend the Commission for requesting comment on possible measures to improve information disclosed to investors about these costs.
As a preliminary matter, we note that the Concept Release pertains only to the disclosure of costs associated with the trading of securities by mutual funds. If the purpose of the Concept Release is to identify methods to improve the disclosure of information to assist investors in understanding the costs of their investments, we believe it would benefit investors if the transaction costs associated with other types of investment vehicles, e.g., hedge funds and wrap accounts, also are disclosed. We therefore recommend that the Commission extend any proposals in this area to investment vehicles other than mutual funds.
I. Summary of Institute Recommendations
The Commission and the industry have long sought ways to improve the disclosure provided to investors about fund fees and expenses generally.3 Recently, there has been an increased focus on ways to improve investor understanding of fund portfolio transaction costs.4 There appears to be a lack of consensus, however, as to the best approach for doing so.
Based on a thorough consideration of various approaches for improving portfolio transaction cost disclosure, we recommend that the Commission take the following actions:
Taken together, these new requirements would both significantly improve investor understanding of a fund's transaction costs and also enhance investor protection by formalizing board oversight of those costs.
While the Institute supports enhanced disclosure of commission costs, we do not believe these costs should be included in fund fee tables or expense ratios, as doing so would diminish the ability of investors to use this information to compare the costs of different funds. We also do not believe it would be in the best interests of investors to require funds to disclose an "all-in" measure of all types of transaction costs. There is currently no single, agreed-upon measure of such costs and each of the alternatives discussed in the Concept Release has significant shortcomings.
In this regard, it is important to note that all fund transaction costs are reflected in a fund's total return. The performance information included in the risk-return summary portion of fund prospectuses and in fund performance advertisements is calculated pursuant to a formula prescribed by the Commission, which requires that it be net of all fees and expenses.5 As a result, when investors view this data, they are indirectly taking a fund's fees and expenses, including transaction costs, into account.
Our recommendations and specific comments on the Concept Release are discussed more fully below.
II. Enhanced Disclosure
A. Disclosure of Brokerage Commissions Paid
As the Concept Release notes, the commissions paid by a fund are the only type of transaction cost that can be measured directly. The commission paid for each transaction appears on that trade's confirmation statement and all mutual funds (with the exception of money market funds) are currently required to disclose in their Statements of Additional Information the dollar amount of brokerage commissions that they have paid during their three most recent fiscal years.6
The Institute believes that enhanced disclosure regarding brokerage commissions would improve an investor's overall ability to evaluate and compare fund brokerage costs. We therefore recommend that the Commission require funds to disclose certain information about brokerage commissions paid7 in the financial highlights table. In particular, funds should be required to disclose brokerage commissions paid (1) as a percentage of average net assets and (2) as a percentage of the principal amount of transactions.8 Including this information in the financial highlights table will allow investors to evaluate the commissions in the appropriate context (i.e., backward-looking information on the fund's returns and expenses).
To ensure that these disclosures are meaningful to investors, we recommend that they be accompanied by an explanation of the factors and variables that affect commission rates. For example, disclosure could be made regarding the types and levels of transaction costs associated with different types of securities in which a fund invests. (For example, a fixed-income fund could disclose that trades in its securities typically do not include a commission, but rather a mark-up or mark-down. An international fund could discuss levels of commissions in the principal markets in which it invests.)
In addition, disclosure should be made regarding the portion of trades that are executed on a commission basis, spread basis, or some other basis. This disclosure would clarify that the information about the fund's commissions may relate only to a subset of the fund's portfolio transactions.
We believe that these recommendations would significantly enhance investor understanding of commission costs. We further believe that this approach is preferable to one that would require commissions to be included in the expense ratio and fee table. In contrast to the expense components currently included in fund expense ratios, transaction costs tend to vary from year-to-year. Consequently, their effect on future costs and returns is uncertain. Transaction costs can fluctuate as a result of a number of factors (e.g., market conditions, fund flows, portfolio manager changes). This volatility, which would not necessarily reflect changes in the cost of providing fund services to investors, could create significant confusion with respect to future fund expenses if transaction costs were included in the expense ratio and fee table. Indeed, the volatility in transaction costs is one of the reasons why an advocate for greater fund fee and expense disclosure has expressed opposition to including brokerage costs in expense ratios.9
In addition, because commissions may be the primary type of transaction cost for some types of funds, but not others, including commission costs in the expense ratio would destroy its ability to provide "apples-to-apples" comparisons. In short, while enhanced disclosure of commission costs would be a positive step, including these costs in the expense ratio and fee table is not the way to do so.10
B. Disclosure of Gross Inflows and Outflows
The Concept Release suggests that another approach to providing information about transaction costs would be for funds to provide additional information about the average level of net flows into and out of funds, specifically, the average daily net flow measured as a fraction of total assets. The Institute believes that providing additional information about the sale and redemption of fund shares could be beneficial to investors in assessing portfolio transaction costs that may be generated as a result of investor activity. It also could be useful in informing investors about the level of short-term trading in a fund, which could include market timing. We therefore support additional disclosure along these lines. However, we believe that disclosure of a fund's gross inflows and outflows would be a better indicator of the transaction costs generated by fund flows.11 Situations may arise where the disclosure of net flows could be misleading, e.g., where the inflows and outflows of a fund actively traded by shareholders offset each other over the period, resulting in an average net flow close to zero. We therefore recommend that funds be required to disclose their gross inflows and outflows as a percentage of a fund's average net assets, and suggest that this information be included in the financial highlights table.12
C. Portfolio Turnover
All mutual funds (with the exception of money market funds) are required to disclose in their prospectuses the annual rate of portfolio turnover that they have incurred during the last five fiscal years.13 The Concept Release requests comment on whether additional narrative disclosure concerning portfolio turnover and its relationship to transaction costs should be required. We believe that such additional disclosure would help investors gain a better understanding of a fund's transaction costs.
While portfolio turnover rate is not a perfect proxy for fund trading costs14, it is generally viewed as being highly correlated with transaction costs. In addition, it can be easily calculated by funds, and is easily understood by investors and readily comparable among funds. We believe that these advantages outweigh any imprecision of a portfolio turnover rate's correlation to trading costs. For these reasons, we recommend that a fund's portfolio turnover rate be given greater prominence in a fund's prospectus. Specifically, we recommend that a fund's portfolio turnover rate for each of the five most recently completed fiscal years15 be disclosed in the section of a fund's prospectus discussing its principal investment strategies.16 Such disclosure should be accompanied by narrative disclosure explaining the meaning of portfolio turnover and its relationship to portfolio transaction costs; the impact that a fund's management style would have on portfolio turnover and transaction costs17; and a description of portfolio transaction costs associated with the principal types of securities, or markets, in which the fund will invest.
In addition, we recommend that funds be required to include a standardized legend immediately subsequent to the fee table (1) to alert investors that the figures in the table do not include transaction costs and (2) to reference the section of the prospectus that includes the discussion of the fund's portfolio turnover rate recommended above. This legend would highlight for investors that the fund's transaction costs are not reflected in the figures in the fee table and advise them where they can obtain information about the fund's portfolio turnover rate, which may be viewed as an indirect indicator of those costs.
Finally, we recommend that the Management's Discussion of Fund Performance (MDFP) in annual shareholder reports be required to describe the factors affecting portfolio turnover for the most recently completed period. We believe that including a discussion of a fund's portfolio turnover rate in the context of the MDFP would help investors gain a better understanding of a fund's transaction costs and the impact that they may have on the fund's performance.18
D. Policies Relating to Transaction Costs, Brokerage Allocation and Soft Dollars
The Institute further recommends that funds be required to include in their prospectus disclosure regarding their policies and procedures for monitoring portfolio transaction costs and brokerage allocation that is currently required to be disclosed in Statements of Additional Information.19 The required disclosure would describe how a fund will select brokers to effect securities transactions and how it will evaluate the overall reasonableness of brokerage commissions paid, including the factors that the fund will consider in making those determinations. Our recommendation is intended to give greater prominence to this information by moving it to the fund's prospectus.
The Concept Release discusses the relationship between soft dollars and transaction costs and requests comment on the impact of soft dollar arrangements on a fund's overall transaction costs.20 We believe that investors would benefit by receiving information about a fund's soft dollar arrangements. We therefore recommend that funds be required to provide narrative disclosure of the general types of products and services received, how the fund's adviser utilizes such products and services, whether or not they are unsolicited and what role, if any, they play in selecting brokers. This information would enable investors to assess their funds' soft dollar policies and the extent to which fund brokerage is used to obtain research services.
III. Review of Transaction Costs by Fund Directors
The Concept Release discusses the role of fund boards in reviewing the fund's portfolio transaction costs and requests comment on several issues relating to the board's review. In describing the board's role, the Concept Release states that, because transaction costs are not readily available to investors, it is imperative that directors both understand and heavily scrutinize the payment of transaction costs by the fund and that the fund's board demand all relevant information that is needed to undertake this review process.
As the Release notes, the transaction costs incurred by a mutual fund are generally reviewed by the fund's board because Section 15(c) of the Investment Company Act of 1940 requires a board to request and review such information as may reasonably be necessary to evaluate the terms of the advisory contract between the adviser and the fund.21 In addition, our members report that boards currently receive a large amount of information concerning transaction costs and that many boards have separate committees established to review brokerage issues. Nevertheless, we believe the requirements for board review of transaction costs can be improved. One suggestion would be to require boards to approve the policies and procedures of the fund's adviser for reviewing transaction costs. We also recommend that advisers be required to provide boards with reports on a periodic basis (e.g., annually) containing certain information about the fund's transaction costs.22 For example, such information could include an internal allocation of the adviser's use of brokerage commissions, indicating the amounts paid by the adviser to brokers for execution-only services and the amounts paid to brokers to obtain execution services and research and products under Section 28(e) of the Exchange Act.23
IV. Proposals to Quantify All Transaction Costs
The Concept Release requests comment on the feasibility of attempting to quantify all transaction-related costs incurred by funds and requiring funds to disclose such a measure.24 For the reasons set forth below, we do not believe that it would be appropriate for the Commission to take this step.
A. There is No Single Agreed-Upon Measure of Transaction Costs
Market participants, academics and others utilize various different measures of transaction costs. The Concept Release discusses a few of these approaches, including comparing the actual price that was paid in each transaction with the market price at some time before or after the transaction was completed ("before trade" or "after trade" measurements),25 and using the "implementation shortfall" method.26 In addition to these approaches, funds employ several other measures and benchmarks to estimate their transaction costs, including utilizing the volume weighted average price ("VWAP"). Consulting firms also have developed various quantitative tools that attempt to estimate transaction costs using a variety and combination of these approaches. Nevertheless, to the best of our knowledge, there is no single generally-accepted method or product that has been developed to capture all the necessary and relevant data from a fund and generate objective and consistent measurements.27
Because of this lack of a single standard, funds currently utilize various measurement alternatives to monitor and evaluate their portfolio transaction costs.28 Different funds use different measures for a variety of reasons, including, for example, the size of the fund complex, availability of resources, a fund's investment objectives and strategies (e.g., index funds, momentum funds and international funds may all utilize different measurements), and the markets in which their portfolio securities trade. We further note that it is generally not feasible to measure portfolio transaction costs of fixed-income securities using the existing alternatives because of the lack of reliable market data in the fixed-income securities markets.
B. Existing Measures Have Significant Limitations
Each of the existing measurements of transaction costs has significant limitations. Several of the methods would include some, but not all, of the components of transaction costs, thereby presenting an incomplete picture of these costs to investors. The manner in which a trader executes an order also may bias transaction cost measurements under these methods, such as when traders fill a large order in multiple parts or when a trader pursues momentum or contrarian trading strategies.29 Because of these limitations, several of the measures are open to being "gamed" and therefore could encourage the execution of transactions in a manner that is intended to minimize transaction costs, potentially at the expense of what may be the best overall trade for a fund.
For example, assume that a buy order for a stock with an opening price of $20.00 is received by a fund's trading desk at 11:00 a.m., when the market price of the stock is $21.10. If a "before trade" measurement is used and the benchmark is the opening price of the stock, the fund would have an incentive to wait to execute the order hoping the price will drop below $20.00. If the stock does not reach that price point, however, the order may not be executed that day or may be executed at a price even higher than the 11:00 am price, to the detriment of the fund's shareholders.
Conversely, if an "after trade" measurement is used and the benchmark is the closing price of the stock, the fund would have an incentive to wait to trade until close to the end of the day, in order to ensure that its transaction costs will not stray too much above or below the closing price. The execution price for the stock, however, may be higher at that time than it would have been earlier in the day. Using VWAP to measure transaction costs raises similar concerns, as a fund would have an incentive to execute orders later in the day, once it has an indication of what a security's VWAP will be. This could cause the fund, however, to pay a higher execution price or forego an investment opportunity.
The implementation shortfall method also has its limitations. Most notably, there is no generally accepted method to calculate a portfolio's implementation shortfall. Using the example discussed above, if an order were submitted at or before the open and the stock was executed at 2:00 p.m. at a price of $21.25, the implementation shortfall cost would be $1.25 (the difference between the execution price of $21.25 and the opening price of $20.00). If the order were submitted at 11:00 a.m., the transaction cost would be $.15 (the difference between the execution price of $21.25 and the market price at 11:00 am of $21.10). Therefore, two different transaction costs would result ($1.25 or $.15) depending on when the order was submitted, even though the same execution price for the stock was obtained. Consequently, if two funds each bought this stock but submitted their orders at the specified times above, one fund would report higher transaction costs even though the effect on both funds' total return would be identical.
Finally, the Concept Release requests comment on the "trade effect" measure, which, according to the Release, would reflect the annual average daily difference between the actual value of the portfolio as of the close of each trading day and the hypothetical value of the portfolio if no trades had been made that day. The primary problem with "trade effect" is that this method not only measures a fund's transaction costs but also the fund's short term trading profits and losses and therefore is not a "pure" measure of transaction costs. In addition, as the Concept Release notes, while it might seem most natural to measure trade effect over the trading day on which each trade occurred, this could cause some funds to shift their trading towards the end of the day to minimize reported trade costs, to the possible detriment of the fund's shareholders. In response, the Concept Release suggests using the next day's closing price as the benchmark to address this problem. The use of that benchmark, however, may be problematic because it is not clear that the potential variability due to unpredictable market fluctuations can be fully eliminated.30
C. Recordkeeping and Operational Burdens Would Be Significant
Mandating the use of any of the measures discussed above to quantify and disclose transaction costs would place an enormous burden on funds in terms of recordkeeping and operational requirements. Funds would need to collect and examine data whenever a decision is made that affects the outcome of a trade by the portfolio manager, the trader and the broker (e.g., the time horizon, target price and quantity elements of each trade) as well as determine when a trading decision has actually been made, when that decision has been modified, and determine the market price of the security at each of these times. While many fund advisers have systems in place to record the time at which a trader receives an order, others lack systems to record the applicable market data at that point in time. Therefore, requiring funds to quantify and disclose transaction costs could be extremely costly, especially for small and midsize fund complexes.
For all of the above reasons, we would strongly oppose requiring funds to measure and disclose their total transaction costs utilizing any of the methodologies set forth in the Concept Release. We believe, instead, that the suggestions set forth earlier in our letter - which include both additional quantitative and narrative disclosure, as well as enhanced board oversight, would be far more beneficial to investors, and would avoid the potential adverse effects noted above.
V. Accounting Issues
The Concept Release also requests comment on whether it would be feasible to account for some or all transaction costs as an expense in fund financial statements or appropriate to include some or all of these costs in a fund's expense ratio and fee table without accounting for these items as an expense in the fund's financial statements.
We do not believe that commissions paid should be reflected as an expense in fund financial statements. Commission costs are the equivalent of acquisition or disposition costs incurred on physical assets and generally accepted accounting principles dictate that they be included in the cost basis of securities purchased or deducted from the proceeds of securities sold.31 Causing commissions paid to be treated as fund expenses would understate net investment income and overstate unrealized/realized gains. It would also cause "book-tax differences" (i.e., financial accounting income and capital gains would be different than taxable income and capital gains) necessitating additional recordkeeping efforts by fund managers, the costs of which would likely be passed on to fund shareholders. Moreover, inasmuch as certain portfolio transactions are conducted on a net basis with no explicit commission, expensing commissions paid would diminish investors' ability to compare expenses between funds.
The Concept Release also requests comment on whether commission costs that do not relate to execution and clearing (i.e., soft dollars) should be included as an expense in fund financial statements or expense ratios. We would not support such a requirement. It is difficult if not impossible to break out commissions paid for proprietary research. As Commission staff has previously noted, where the purchase or sale price of a security includes transaction costs that have been incurred for other reasons, but are difficult to separately identify and remove from the overall purchase or sales price, accounting theory recognizes that it would be neither feasible nor practical to account for these costs as a fund expense.32
Other types of transaction costs (e.g., spread costs, market impact costs, opportunity costs) also should not be included as expenses in fund financial statements. For the reasons discussed above, we do not believe that these costs can be reliably measured with the degree of precision necessary to include them in financial statements. Moreover, these costs - like commissions - constitute acquisition and disposition costs, which, as described above, are included in the cost basis of securities purchased or reduce the proceeds of sales.33 In addition, it is likely that they would not be considered to be expenses for financial accounting purposes.34 Finally, if these transaction costs are required to be separately recognized in fund financial statements (as either acquisition/disposition costs or as expenses), fund officers would likely have difficulty certifying the accuracy of financial statements and independent accountants would likely qualify their audit opinions.
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The Institute appreciates the opportunity to provide comments on the Concept Release. If you have any questions regarding our comments, or would like any additional information, please contact me at (202) 326-5824 or Ari Burstein at (202) 371-5408.
Amy B.R. Lancellotta