AMERICAN BAR ASSOCIATION
BUSINESS LAW SECTION
February 21, 2003
Via e-mail - email@example.com
Securities and Exchange Commission
Re: File No. S7-51-02
Ladies and Gentlemen:
We submit this letter on behalf of the Committee on Federal Regulation of Securities of the American Bar Association's Section of Business Law (the "Committee")( in response to a request for comment by the Securities and Exchange Commission (the "Commission") on proposed rule and form amendments under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940 to improve the periodic disclosure provided by registered management investment companies about their portfolio investments, costs, and past performance.1
The comments expressed in this letter represent the views of the Committee only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the Association. In addition, this letter does not represent the official position of the ABA Section of Business Law, nor does it necessarily reflect the views of all members of the Committee.
As a preliminary matter, the Committee agrees with the Commission that shareholder reports are one of the principal means by which funds provide periodic financial information to their investors. We also agree that, with some modifications, fund shareholder reports could become a more effective vehicle for communicating information to investors. Accordingly, we support the proposed amendments in many respects, including providing summary portfolio schedules to fund shareholders. The Committee, however, respectfully questions whether other aspects of the proposed amendments are legally necessary or appropriate, particularly quarterly filings of complete portfolio holdings given the improbable benefit and possible harm to fund shareholders and the potentially significant compliance costs.
Summary Disclosure of Portfolio Holdings
The Committee supports the proposal to permit a fund to disclose in shareholder reports the fund's 50 largest holdings and holdings that account for one percent or greater of the fund's net assets. This standard should allow the average investor to focus on a fund's principal holdings without being subject to "information overload." Studies have shown that consumers tend to ignore information when presented with too much data.2 While industry participants may be in a better position to comment on compliance costs, its seems most efficient to use the same 50-issuer standard for all funds. For this reason, we do not believe that a fund should have a certain minimum number of securities to utilize a summary portfolio schedule.
With respect to index funds and money markets funds, the Committee believes that these funds should be exempt from the requirement to include their portfolio holdings in their reports to shareholders, as long as this information is filed with the Commission. A fund that holds itself out as an index fund is required to track its designated index or risk a Commission action under Section 35(d) of the Investment Company Act.3 A money market fund, of course, must comply with the much more restrictive portfolio holding requirements of Rule 2a-7 under the Act.4 Given the tight portfolio restrictions of index funds and money market funds, it is difficult to see the value to investors of providing even the top 50 holdings in shareholder reports.
In addition, Form N-CSR, in our view, would be the appropriate location for a fund to include a summary portfolio holdings schedule.
Tabular or Graphic Presentation of Portfolio Holdings
The Committee supports the proposal to require a fund to include in its reports to shareholders a presentation using a table, chart or graph that depicts a fund's portfolio holdings by reasonably identifiable categories. We agree that such a presentation could illustrate, in a concise and user-friendly format, the allocation of a fund's investments across asset classes.
We furthermore support this aspect of the proposed amendments for all funds regardless of the number of portfolio holdings of a fund. However, a particular format of presentation should not be mandated. In our view, the Commission's proposal provides for an appropriate balance between requiring some form of table, chart or graph - and providing a fund with the flexibility to format a presentation that best illustrates its portfolio composition.
Quarterly Filing of Complete Portfolio Schedule
With regard to a cost/benefit analysis of quarterly filings of complete portfolio schedules, industry participants who will be directly affected by the potentially significant costs of compliance may be in a better position to comment on the likely burden of this proposal. However, the Committee questions the likely benefit to fund shareholders and is concerned about the likely harm. Consequently, we question whether new law in this area is necessary or appropriate.
An industry study has found that frequent portfolio disclosure would result in lower realized returns for fund shareholders.5 Specifically, the study cites increased costs associated with front running, free riding, liquidity and tax-management strategies as the source of the reduced total return for shareholders.6 Frequent disclosure of portfolio holdings could encourage front running by professional investors who receive current and comprehensive portfolio information.7 The information disclosed in shareholder reports would enable these professional investors to better anticipate fund trades and capture the price impact by trading ahead of funds. Front running could raise prices for fund purchases of securities and lower prices for fund sales and, therefore, lead to lower realized returns for shareholders.
The study also concludes that frequent disclosure of portfolio holdings could cause free riding by permitting outsiders to benefit from fund research and duplicate the funds' holdings or investment strategies.8 Increased free riding activities could cause security prices to move before a fund could fully implement its research efforts and thus, reduce the returns to shareholders.
Given the study's findings and conclusions, the Committee is concerned about the likely harm to fund shareholders from quarterly filings of complete portfolio schedules. We also question the likely benefit to shareholders if this proposal is adopted. While certain trade groups have called for rulemaking in this area, industry participants have observed virtually no demand from fund shareholders. Coupled with potentially significant compliance costs, the legal merit of this proposal is questionable. Accordingly, we do not support this proposal.
If, however, the Commission adopts this proposal substantially as proposed, we suggest that the rules should allow funds to provide this information solely by posting it on their websites. The Commission has followed this approach in its rules concerning disclosure of proxy votes.9
Disclosure of Fund Expenses
The Committee agrees with the Commission that fee disclosure is a central feature of the federal securities laws. We also applaud the Commission and the SEC staff's efforts over the past several years to focus attention in this area to make fee disclosure more effective and useful.10 We, therefore, generally support the proposal to require mutual funds to include in reports to shareholders the dollar cost associated with a $10,000 investment.
At the same time, the required fee disclosure for funds is currently user-friendly and comprehensive. Item 3 of Form N-1A, a mutual fund's registration statement, requires a fund to disclose in its prospectus a fee table that included all fees and charges associated with an investment in the fund. The table is accompanied by a numerical example that illustrates what an investor could expect to pay over specified time periods. Because of the requirements of current law, the benefits of additional disclosure appear marginal at best.
With regard to the cost of implementing this aspect of the proposed amendments, the Committee believes that industry participants who will be directly affected by the potentially significant compliance costs again may be in a better position to comment on the likely burden of this proposal. 11
Management's Discussion of Fund Performance ("MDFP")
We support the Commission's proposal to require that MDFP be included in annual reports to shareholders. We agree that MDFP would fit naturally with other "backward looking" information contained in the annual report, such as the fund's financial statements.
The Committee respectfully submits these comments and requests that the Commission revise the proposed amendments in accordance with the comments set forth in this letter. Members of the Committee's Subcommittee on Investment Companies and Investment Advisers are prepared to meet and discuss these matters with the Commission and the staff and to respond to any questions.
cc: The Honorable William H. Donaldson
The Honorable Paul S. Atkins
The Honorable Roel C. Campos
The Honorable Cynthia A. Glassman
The Honorable Harvey J. Goldschmid
Paul F. Roye
|*||References to "we" and "our" refer to the Committee.|
|1||Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management Investment Companies, Release Nos. 33-8164, 34-47023, IC-25870 (Sept. 18, 2002).|
|2||Consumers may make incorrect decisions when they are required to process too much information; they do well with moderate amounts of data but poorly when data sets become too large. In other words, they suffer from "information overload." Naresh K. Malhotra, Reflections on the Information Overload Paradigm in Consumer Decision Making, 10 J. Consumer Res. 436 (1984). Consumers tend to ignore information when presented with too much data. Jacob Jacoby, Perspectives on Information Overload, 10 J. Consumer Res. 432 (1984); see also Naresh K. Malhotra, Information Load and Consumer Decision Making, 8 J. Consumer Res. 419 (1982); Robert E. Scott, Error and Rationality in Individual Decisionmaking: An Essay on the Relationship Between Cognitive Illusions and the Management of Choices, 59 S. Cal. L. Rev. 329 (1986).|
|3||15 U.S.C. § 80a-34(d).|
|4||17 C.F.R. § 270.2a-7.|
|5||Russ Wermers, The Potential Effects of More Frequent Portfolio Disclosure on Mutual Fund Performance, ICI Perspective (June 2001), available at http://www.ici.org/pdf/per07-03.pdf.|
|9||See, Disclosure of Proxy Voting Policies and Proxy Voting Records by Management Investment Companies, Securities Act Rel. No. 8188, Exchange Act Rel. No. 47304, Investment Company Act Rel. No. 25922 (January 31, 2003).|
|10||See, e.g., Report on Mutual Fund Fees and Expenses, Division of Investment Management, SEC (Dec. 2000).|
|11|| Some members of the Committee have expressed the view that as compared to the Commission's proposal may be less costly and more effective than the proposal of the General Accounting Office in allowing their clients to compare costs between different fund families than the Commission's proposal. See, GAO, Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition (June 7, 2000).