January 13, 2003
"Would quarterly disclosure of portfolio holdings deter portfolio manipulation, such as 'window dressing' and 'portfolio pumping'? Are there additional ways to inhibit or curb these practices?" Proposed rule and form amendments; File No. S7-51-02
These comments are intended only to address the second of the above questions.
Just as not all the pertinent questions about a company can be understood by looking at its balance sheet, so not all the pertinent questions about a mutual fund can be understood by looking at the moment-in-time snapshot of portfolio holdings that funds currently provide.
It is the contention of these comments that mutual fund disclosure from a point of view other than that of the portfolio holdings schedule would provide a significantly better deterrence to 'window dressing.'
As an example lets look at a mutual fund's disaggregated performance results ["DAPR" for brevity's sake]. Such disclosure would show the fund's realized and unrealized gains and losses in individual securities that it invested in over the course of a quarter, six months, or whatever period the Commission chose.
A hypothetical example of DAPR follows:
The fund's net assets at the beginning of the period [October 1] were $1,000,000
The fund then bought 2000 shares of XYZ Company at $50 for a total of $100,000 on Oct. 10
The fund sold 1,500 shares of XYZ Company at $55 for $82,500 on Nov. 15.
The fund still owned 500 shares of XYZ Company at $48 or $24,000 at the end of period [Dec. 31]
So what did the fund's investment activity in this security contribute to the performance of our hypothetical mutual fund over the period? By my inexpert calculations roughly +0.65% [$82,5000 realized proceeds, plus $24,000 unrealized value, minus $100,000 initial cost of shares equals $6,500]. That $6,500 divided by the one million dollars beginning-of-period net assets equals 0.65%. 1
Obviously the DAPR calculation could be far more complex depending on whether it took into account brokerage commissions, dividends, taxes and other items. I am an investment advisor, not an expert on performance reporting, and defer to more adept minds on those issues. 2
The 0.65% percentage contribution by the fund's investment activity in XYZ Company could then be disclosed in a DAPR schedule, which might look something like the following:
"The fund's investment activity in the following securities affected the fund's assets during the preceding period by the following amounts [negative returns are in parentheses]:
DAPR disclosure would deter "window dressing" by preventing its intended outcome, which is to give shareholders an erroneous impression. In the hypothetical illustration above, DAPR makes it obvious that Level 3 Communications had in fact been in the fund's portfolio at some time during the reporting period and that it had been a major detractor from the fund's performance. With DAPR the fund manager could no longer hide those facts by making Level 3 Communications disappear from the fund's portfolio before the reporting date.
Similarly, on the other side of window dressing, a manager would gain no public relations value by adding a glamour security after it already had a huge run-up. A DAPR schedule would reveal that the security did not contribute materially to the fund's performance, and thus was probably not owned in any significant amount prior to the run-up.
DAPR disclosure would provide several other advantages over simply increasing the frequency of portfolio holdings disclosure:
Because the DAPR would only report on a fund's past investment performance, it would provide no definitive help to outsiders attempting to "front run" the fund's portfolio. Just because a security had contributed, positively or negatively, to a fund's performance at some point during the preceding period would not indicate whether that security still was or was not in the portfolio.
And note that if a DAPR schedule were limited to material gains or losses, fund managers who are trying to initiate a new position in a security would not likely have to worry about that security appearing in a DAPR schedule as the newly acquired positions are likely to be smaller and, would be less likely to have had time to show a sizeable gain or loss.
As the Commission has, in this proposed rulemaking expressed (in my opinion, justifiably) concern about the quality of mutual funds' "Management's Discussion of Fund Performance" [MDFP] it is also worth noting that the DAPR schedule would provide a minimum record of what a mutual fund did during the reporting period. All too often, MDFP's consist of little more than boilerplate observations about the economy and the markets, leaving current and potential investors with no way to understand why their fund's manager may have under performed or outperformed the fund's benchmark.
By contrast DAPR would show what happened to an investor's money over the preceding period and, being quantitative, would help facilitate comparison with other mutual funds.
DAPR could provide even an inexpert investor with other valuable information.
For instance it would tell the investor whether a fund's overall gain or loss was dependent on just a couple of stocks, or whether it was broad based. By comparing the DAPR performance for an individual security with its price change over the same period one could form a general conclusion as to whether "active" management of the fund added or substracted value versus what one would have gotten with just a buy-and-hold of the same security.
With DAPR an investor would be able to tell if a material amount of the fund's performance came from IPO's. In combination with a portfolio schedule an investor could also tell if significant fund performance came from securities that were also bought by other funds in the same fund family.
As was mentioned at the beginning of these comments, no one type of statistic or schedule can address all the reasonable information needs of investors. DAPR for instance would probably have little or no affect on "portfolio pumping." Nor would it directly address "style drift." However it would let the investor know something very important: whether the style drift was very costly or beneficial to the fund. Simply increasing the frequency of portfolio schedules wouldn't necessarily address style drift since fund managers would still have the ability to cover up their style transgressions by ridding their portfolios of the offending holdings just prior to the record date.
The preceding points, I think, make amply clear that information about a fund's investment activity over the course of the reporting period significantly improves the ability of potential investors to understand a mutual fund, and of the fund's current owners to monitor their investment. The preceding I think also makes clear that DAPR would be a valuable compliment to a portfolio schedule, and in some respects is a substantial improvement over a portfolio schedule.
I thank the Commission for providing me the opportunity to submit comments on this proposed rulemaking.
1 Note that DAPR disclosure contains more information than simply comparing the value of the holding from portfolio schedule to the next. If one were limited just to the portfolio schedule the only conclusion available, based on the information, was that the fund had lost money on that security [$50 at the beginning of the period and $48 now], when in fact the fund had made money on its investing in XYZ company.
2 I would think that all the information required to compile a DAPR schedule, essentially transaction prices and closing prices as of the reporting date, are already gathered by the fund management. They may already perform many of the DAPR calculations for tax purposes or to calculate performance-based compensation.