Via E-mail and Federal Express
June 30, 2000
Mr. Jonathan G. Katz, Secretary
U.S. Securities and Exchange Commission
450 Fifth Street, NW - - Mail Stop 0609
Washington, D.C. 20549-0609
Re: Proposed Disclosure of Mutual Fund After-Tax Returns
File No. S7-09-00
Dear Mr. Katz:
This letter presents the comments of Federated Investors, Inc. ("Federated")1 regarding the proposal of the Securities and Exchange Commission ("Commission") to amend various rules and forms to increase disclosures by mutual funds with respect to the effects of taxes on investment returns (the "Proposal").2 At the heart of the Proposal is a requirement that mutual funds disclose after-tax performance return numbers based on standardized formulas.
We understand the underlying goal of the Proposal is to improve investor appreciation of the effects of taxes on investments in mutual funds through additional disclosure. Federated believes that the financial markets and media are already working to address this, and that the Proposal will not materially help their efforts. Moreover, the same Congress now clamoring for after-tax return disclosure has authored a tax code of staggering complexity, particular concerning investments. The complexity and nuances of mutual fund taxation make it impossible to provide a single "after-tax" performance number, or even a manageable series of numbers, that would meaningfully help investors. Federated contends that the complex nature of the issue, not the desire to disguise the impact of taxes on fund returns, explains why the market does not provide standardized after-tax returns to investors already.
Consequently, Federated believes that adoption of the Proposal will subvert the Commission's recent efforts to improve prospectus disclosure without advancing the understanding of most investors regarding the impact of taxes on their returns. When adopting new Form N-1A, the Commission professed a desire to avoid legal technicality and promote brevity and plain English in disclosure. The Commission cannot possibly square this desire with the lengthy boilerplate explanation of underlying assumptions and qualifications that will necessarily accompany the after-tax returns mandated in the Proposal. Adoption of the Proposal would represent a step back from prospectus simplification.
Therefore, although Federated supports the goal of helping investors understand the effects of taxes on their investments, we cannot support the Proposal. Federated believes that the Commission should allow the market to respond, perhaps pointing out that the data necessary to make after-tax return calculations are already available in the Financial Highlights section of every prospectus. We are confident that this will lead to the development of after-tax performance information and rankings tailored to the circumstances of individual investors.3 The only regulations that Federated would support in this context would be standardized after-tax performance calculations for investment companies that choose to publish this information in prospectuses or sales literature.
However, if the Commission determines that investment companies must provide additional tax information, then Federated believes strongly that the Commission should not force registrants to publish (and incur prospectus liability for) hypothetical performance numbers of any type, particularly numbers reflecting a host of arbitrary assumptions. Federated would therefore encourage the Commission to consider an alternative approach identified by the Investment Company Institute ("ICI"), which we expect will be included in the ICI's comment letter on the Proposal, and which we discuss further below.4 Finally, if the Commission insists upon pursuing the proposed course, Federated would urge the Commission not to further confuse matters by adjusting performance for front or back-end fees and sales charges. Otherwise, Federated would support the other comments made in the ICI's letter, except that we believe that any after-tax disclosure requirement should apply to bond funds. Our comments on these issues and other aspects of the Proposal are set forth in detail below.
The Commission Should Not Require Registrants to Publish (and Incur Prospectus Liability for) Hypothetical Performance Figures that Could Mislead Investors.
As noted in part II. F. of the Release,
The computation of after-tax return depends on several assumptions, such as tax bracket, that vary from investor to investor. As a result, the proposed standardized after-tax return measures are not intended as precise computations of any individual investor's after-tax returns from a fund, but as guides to understanding the effect of taxes on the fund's performance.
We believe the Commission understates the situation. The point is not merely that the prescribed after-tax numbers "are not intended as precise computations of any individual investor's after-tax returns from a fund;" the fact of the matter is that these numbers (regardless of which set of calculation assumptions is ultimately imposed) are almost certain not to reflect the actual experience of any shareholder. The Commission needs to realize and acknowledge that it will be forcing registrants to publish hypothetical performance numbers in their prospectuses.
We strongly believe that use of hypothetical performance numbers, however laudable the purpose might be, is highly suspect, and that the Commission would be taking extreme liberties with the potential liabilities of registrants and their directors, officers, and underwriters by requiring use of such numbers in a registration statement. Our concern is that, notwithstanding the Commission's intention, and regardless of the clarity and prominence of any disclosure a registrant could add to emphasize the hypothetical nature of the after-tax performance numbers, some investors will, inevitably, be mislead. No matter how prominent the disclaimer, some investors will assume that their personal rates of return correspond to the hypotheticals. Moreover, given the frequency of changes in tax rates and rules and the impact of individual factors on taxes, investors, at a minimum, will be confused in attempting to extrapolate from the examples ("guides") to their own personal situation.
We infer that the Commission was not totally insensitive to such concerns, as the above quoted passage of the Release goes on, in an apparent attempt to justify this approach, to argue that:
In this regard, the proposed standardized after-tax return measures are similar to the standardized before-tax returns, which also are dependent on assumptions such as the purchase and sale date of fund shares, and do not precisely measure an individual investor's before-tax returns.
We must disagree. In our view, the Commission overstates the similarity between the Proposal and the standard before-tax numbers. While it is certainly true that funds calculate their before-tax standard returns using certain prescribed assumptions, it is also true that there are many investors for whom the resulting numbers would accurately reflect their personal returns on an investment in the fund over the course of the periods shown. While this is particularly the case for "buy-and-hold" investors in "no-load" funds, the ability of load funds to complement the standard numbers with no-load numbers also results in accurate performance figures for their buy-and-hold investors. As noted above, the same cannot be said for the proposed after-tax return figures. Indeed, to take just one example, the proposed assumption that income and short-term gains are taxed at the current maximum marginal federal rate of 39.6% assures that the proposed after-tax numbers will have no direct relevance to (according to the ICI) the 99% of fund shareholders who are taxed in lower brackets. Thus, the Proposal would require numbers that would, for virtually all investors, overstate (perhaps vastly) their personal (federal) tax consequences, while understating their true after-(federal) tax returns. To our eyes, this is misleading information.5
The Commission Should Consider Less Troubling Alternatives
Our concerns with the Commission's approach to the underlying issue of how to provide better disclosure of the tax effects of investing are compounded because it does not appear that the Commission considered alternatives that would not be misleading. Providing after-tax performance numbers is only one way (albeit, the most troubling way) of expanding disclosure in this area. There appears to be at least one alternative approach (for which we give credit to the ICI) that would give all investors the means to gauge tax effects on a personal basis and enable them to make meaningful comparisons among different funds. Specifically, funds could be required to disclose the portion of their total returns attributable to amounts (a) not currently taxed, (b) taxed as ordinary income, and (c) taxed as long-term capital gains.6
To us, this approach is clearly preferable to a requirement to furnish hypothetical after-tax performance numbers. Foremost, it is not misleading. Moreover, the information is relevant to, and could reliably be used by, all shareholders. It would enable shareholders to produce accurate after-tax numbers that are based on their individual circumstances, if they wish to do so. It would also allow investment professionals, ranking services, the media, and perhaps even the Commission (see footnote 3 above) to experiment with different presentations of the information, allowing investors to choose which are most informative.
Importantly, this approach would also be useful to those shareholders who choose not to compute their own returns. As noted in part I. of the Release, one aspect of the Commission's objective in this area is to help investors compare the impact of taxes on the performance of different funds. Breaking down a fund's total return into its three components using this alternative approach would enable shareholders to do precisely this. In fact, this approach would enable shareholders to make these comparisons more easily and accurately than under the Proposal. This is because, as noted above, the proposed assumptions would result in overstating and distorting the tax effects, which would require shareholders to somehow compensate for these shortcomings in order to arrive at usefully comparable return figures. Under the alternative approach, shareholders (even those who are not particularly mathematically adept) could take two funds with very similar "standard" total returns and readily identify any differences in tax consequences.7
We are concerned that, despite the obvious merits of this approach, it does not appear that the Commission has even considered it (let alone requested comment on it). In light of the deficiencies and risks posed by the approach put forth in the Proposal, we urge the Commission to seriously consider this and other possible alternative approaches before taking any final action in this important area.
Although we are hopeful that the Commission will decide to address this subject in a way that does not force registrants to issue misleading information, we still believe it would be prudent to comment on additional aspects of the Proposal. In this regard, Federated agrees with many of the points we expect to be raised in the ICI comment letter. In particular, we agree that after-tax return numbers, if required at all, should only be required in the prospectus, and not also in "Management's Discussion of Fund Performance." We also agree that such disclosure best belongs in the tax section of the prospectus, and not (as proposed) in the risk/return summary. Accordingly, the following comments only address the required presentation of information in registration statements; we are not addressing what requirements should apply if a fund chooses to advertise after-tax performance.
Funds Cannot Provide Useful Tax Disclosure Using Numbers that Show the Effects of Taxes and Sales Charges and Other Fees
Under the Proposal, funds would be required to present in a standardized tabular format before-tax and after-tax returns for 1-, 5-, and 10-year periods on a pre-liquidation basis and post-liquidation basis for each class of shares offered by the fund. The four types of return for each class would be as follows:
In each case, the prescribed calculation formula would require (among other things) an assumed initial investment of $1,000, from which is deducted the maximum sales load (or other charges deducted from payments). Thus, some of the required numbers will reflect all sales charges and fees, while others will reflect only front-end charges.
The proposed approach obscures the very information that the Proposal purports to be seeking: the effect of taxes on investment returns. Moreover, in our view, such an approach is virtually guaranteed to confuse investors. Showing investors a "mixed bag" of numbers that are not calculated on a uniform basis will neither further the Commission's stated goal nor advance investor understanding.
The clearest way to show the effect of taxes using performance numbers is to provide numbers that show only the effect of taxes, i.e., no-load numbers. In our view, the Commission should take the same approach to illustrating the effects of taxes that it took with respect to illustrating the variability of a fund's returns in the "Bar Chart" currently required by Item 2 of Form N-1A. In adopting the current bar chart requirement to show year-by-year performance on a no-load basis, the Commission "concluded that more precise return information [i.e., data reflecting sales charges] is not necessary for the bar chart to serve the purpose of graphically showing fund returns and illustrating the variability of an investment in a fund over a 10-year period."8 We believe the case for using no-load numbers to illustrate the effects of taxes is even more compelling. Not only is it not necessary here to include the effects of sales charges and other fees, but including such items will actually impede an investor's ability to assess the tax effects and to make comparisons among funds based on tax effects by "cluttering" the numbers with variable information that has no direct bearing on taxes. The fact that under the Proposal the sales charge assumptions are not uniform only compounds the negative effects.
Requiring the after-tax numbers to exclude sales and other charges would, in our view, have other beneficial effects. It would permit a "cleaner," simpler presentation under which only three sets of numbers would be necessary:
The before-tax returns would complement the information in the bar chart, by presenting the same data in "average annual" (vs. year-by-year) form. As with the bar chart, such an approach would also obviate the need (or desirability) of showing these sets of numbers for each class of shares offered in a multi-class prospectus.9 Under our approach, the fund would present the tax-related performance information for the same class used in the bar chart illustration. Given our concerns with any use of such hypothetical performance figures, if the Commission nevertheless decides to impose such a requirement, we think it would reinforce the point that the numbers are merely illustrative if they are only given for one class. We fear that giving sets of numbers for each class would tend to foster the (mistaken) impression that these are precise and useable numbers.
We understand that the ICI may argue for similar simplifications based on standardizing the load and other charges assumptions, but would achieve standardization by requiring that all loads and charges (including exit fees) be reflected in all tax-related numbers, even the numbers that purport to show pre-liquidation after-tax returns (which might be referred to in the ICI's submission as "Returns reflecting the impact of taxes on fund distributions"). In other words, under the ICI's proposal, we would have to show shareholders a number that assumes that they continue to hold their shares, and yet also reflects the effects on performance of fees that are incurred only when they sell their shares. In our view, such an approach will not improve investor understanding.
Tax-Exempt Funds and Other Bond Funds Should Not Be Exempt from the Disclosure Requirement
The Proposal would, with very limited exceptions, apply equally to equity funds and bond funds. However, the Commission sought specific comment on whether tax-exempt funds, or any other types of funds, should be excluded from the disclosure requirement. We understand that the ICI will suggest that all "bond funds" be exempted. Federated cannot support the ICI's rationale for this exemption, and believes that it would omit the one class of mutual funds that could actually benefit from the Proposal, namely tax-exempt funds.
The ICI's proposed exemption would be appropriate if investors purchased bond funds based solely on their yield. However, bond funds publish total return numbers and, more importantly, are ranked by them. A tax-exempt fund that pays the lowest tax exempt dividend can have five stars and the highest ranking if it has the greatest appreciation and capital gain distribution. Moreover, it has become increasingly difficult to manage funds paying fully tax-exempt dividends.10 It appears to us that, out of all the various categories of investors, those choosing tax-exempt funds would likely have the most interest in seeing additional after-tax return information. While Federated concedes that gains are typically more significant for stock funds than for bond funds, for certain bond funds (e.g., high yield funds) and during volatile markets, gains may also account for much (or most) of the funds' total return. Therefore, Federated cannot find any justification for treating bond funds differently for purposes of after-tax performance disclosure.
* * * * *
Federated very much appreciates having the opportunity to comment on this important Proposal. If you would like to discuss these comments or any other aspects of the Proposal with us, please contact Jay Neuman by phone at (412) 288-7496 or by e-mail at email@example.com. Thank you very much.
Very truly yours,
Jay S. Neuman
cc: Paul F. Roye, Director
Division of Investment Management
|1||Federated is one of the largest asset management and mutual fund firms in the United States. Through its subsidiaries, Federated manages total assets of more than $125 billion and serves as adviser, distributor, and/or administrator for over 450 classes of mutual fund shares.|
|2||The Proposal is set forth in Release No. 33-7809 (March 15, 2000) ("Release") (65 F.R. 15500; March 22, 2000).|
|3||As noted in the Release, calculators that investors can use to compute after-tax returns are already available (text accompanying footnote 9). Given the Commission's continuing efforts to improve the quality of mutual fund disclosure and help investors make better-informed decisions (which was also noted in the Release), the Commission might consider adding a tool to its website that would produce after-tax returns using the data that would be produced under this alternative, as a complement to its "Mutual Fund Cost Calculator."|
|4||In light of the differences in the ICI's proposed approach, Federated believes that the Commission should resubmit any revised proposal for public comment.|
|5||The fact that state and local taxes are excluded from the proposed computation formulas only increases the extent to which use of the resulting numbers would produce inaccurate and potentially misleading information.|
|6||A fund could be required to disclose, for example, that 60 percent of the reported total return was unrealized gain, 30 percent was distributable net long-term capital gain and 10 percent was distributable ordinary income.|
|7||If the Commission were to adopt this approach, we think it would be important to also require narrative disclosure to the effect that shareholders would be taxed on at least some portion of the unrealized gain when shares are redeemed (depending on their cost basis for the shares).|
|8||Release No. 33-7512, March 13, 1998, at text following footnote 63 (adopting amendments to Form N-1A) (63 F.R. 13916, 13923).|
|9||Id., text accompanying footnote 65.|
|10||For example, the tax code requires funds to recognize non-de minimis market discount as ordinary income. During periods of sustained interest rate increases, it can become nearly impossible to acquire tax-exempt bonds in the secondary market without recognizing market discount income. Some funds use market discount to increase their returns; other funds try to avoid market discount to minimize the effect on their dividends. Investors cannot differentiate between these funds using pre-tax numbers.|