Speech by SEC Staff:
Luncheon Address at the 2007 ICI Closed End Fund Workshop
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, New York
October 11, 2007
Thank you very much for inviting me here today. Before I begin, I would like to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the SEC staff.
I also would like to extend a special thanks to the ICI for hosting a day-long program entirely devoted to closed end fund issues. An April 2007 Wall Street Journal article about closed end funds featured the headline: A "Sleepy Corner of the Fund World is Waking Up." I have worked with closed end funds as a general counsel to asset management firms, a fund director and now, of course, as a regulator. As a result, I know that while closed end funds may indeed be "waking up" and receiving significant public attention, the closed end fund market has rarely been a "sleepy" corner of the fund industry.
Closed end funds provide average American investors with the opportunity to gain exposure to certain types of investments not ordinarily available to them through mutual funds. As you are aware, closed end funds differ from mutual funds in part because closed end funds do not have to meet a daily redemption requirement. As a result, closed end funds can invest a significant percentage of assets in less liquid securities, which can include securities in emerging markets as well as derivative instruments and complex securitized structures. In addition, closed end funds have a greater ability than mutual funds to enhance (or diminish) their returns through leverage. Indeed, I understand that earlier today this conference featured an expert panel discussing the myriad of investing strategies that closed end funds have employed in recent years.
Needless to say, these types of investments and investment techniques can often raise significant compliance and risk management issues. These issues can include valuation challenges, appropriate asset coverage tests and concerns about the amount of leverage, including implicit and explicit leverage, that a fund may take on. In addition to these challenges, concerns about secondary market discounts to net asset value have historically been an issue surrounding closed end funds — and these concerns continue to persist today.
I would like to focus, however, on valuation issues. Valuation may not be the first compliance issue you think of when you consider closed end funds — but it is critical nonetheless. Calculating an accurate net asset value is important for any investment company — whether a mutual fund or a closed end fund. One of the hallmarks of the fund industry is the unrelenting commitment to mark to market and fair value, as necessary, in order to value a fund as accurately as possible.
I have a concern, however, that some fund complexes — and perhaps some fund boards — may worry less about the valuation of portfolio securities owned by closed end funds than mutual funds. The logic seems to be that accurate valuation for closed end funds is less important than it is for mutual funds because closed end fund shares are purchased and sold at market prices and not at net asset value. However, my staff and I believe that accurately valuing portfolio securities by closed end funds is critically important for several reasons.
First, closed end fund market prices correlate, at least to some extent, with closed end funds' NAVs. Thus NAVs can affect the market prices at which closed end fund investors purchase and redeem shares. Consequently, it is essential that a closed end fund's NAV be accurate.
Second, investment advisory and other asset based fees are calculated on the basis of a closed end fund's NAV, not its market price. Thus, NAVs must be calculated accurately so that funds pay the correct amount in fees.
The third concern relates to misleading statements. Closed end funds typically publish their NAVs. Miscalculated NAVs can be materially misleading statements, potentially subjecting the fund, its managers and/or its board to liability.
The fourth concern comes directly from the Investment Company Act itself. The Act has very particular provisions regarding the valuation of a fund's assets, including the role of the board in determining the fair value of a security for which market quotations are unavailable. The Act does not exclude closed end funds from this requirement. It is a statutory mandate.
My concerns regarding the accurate valuation of portfolio securities owned by closed end funds have only been heightened by recent events in the subprime market, and their widespread effect on the broader market. Certainly, market events are impacting many of the securities held by closed end funds. Fund boards and fund managers cannot turn a blind eye to this impact when assessing the net asset values of their closed end funds' shares.
Similarly, to the extent that closed end funds may invest more of their assets in less liquid securities than mutual funds do, closed end funds may face a greater valuation challenge. In general, there is a close relationship between the liquidity of a portfolio security and the ease with which the security may be valued. If a security trades in a liquid market, there is a strong likelihood that current market quotations will be readily available and can be used to value the security. Conversely, quotations for a security traded in an illiquid market are often difficult to obtain. Therefore, further consideration should be given to whether market quotations are readily available and thus whether a security should be assigned a fair value.
III. Responsible Product Development
I would now like to shift my focus from the valuation of closed end funds to the creation of closed end funds. The market for closed end funds has been dynamic. My staff estimates that there have been approximately 32 closed end fund IPOs in 2007, and in February the market saw the largest ever closed end fund IPO.
As fund groups and fund boards consider the development and launch of new closed end funds, I am hopeful that these activities are done responsibly and with the best interests of fund investors in mind. A hot investment technique that cannot be sustained is generally not in investors' best interests. In fact, a fund firm can erode its reputation, and ultimately its business, by implying a promised return that cannot be met. I therefore urge fund executives, marketing professionals, portfolio managers, counsel and independent directors to consider not just "what will sell" in the closed end fund space, but also, and more importantly, to consider what will properly serve investors' needs in the closed end fund space.
There is no doubt that America's investors, like America's population, are aging. Many of us in the room today are testament to that fact — myself included. As investors age, they generally move beyond a financial goal of amassing wealth and shift to a phase in which they are more interested in preserving capital and in the income that can be produced from their wealth. The closed end fund industry is well aware of this need among aging investors and has been creating products to meet this need. However, if the distributions that fund investors receive from their funds are a return of capital, rather than traditional income or gain from an investment, I believe that fund investors and prospective investors deserve to know that.
As many of you may be aware, the staff of the Division of Investment Management has expressed concerns about closed end funds' managed distribution plans and whether funds are sending out the required notices. The Investment Company Act prohibits the payment of a dividend or distribution from any source other than net investment income unless the payment is accompanied by a written statement or notice identifying the source of the payment. We have a concern that some closed end funds may not be sending these notices out when required. In addition, we are concerned that these notices are only being received by record holders of a closed end fund's securities and that they are not forwarded on to the beneficial owners. In this case, the ultimate beneficial owners, the actual investors in the fund, may not have meaningful or timely notice of the nature of a dividend or distribution.
The staff also has a concern about whether purchasers and potential purchasers of closed end funds may misunderstand, or even possibly be misled about, the nature of a closed end fund's distributions. Investors may believe that a closed end fund's distribution reflects income and/or gain when, in fact, it may constitute a partial return of capital. Indeed, some third-party information providers report "yield" based on a gross distribution that may consist primarily of return of capital. If total return appears on the same page as the "yield," more often than not it is based on market prices, which may not provide investors and potential investors with a clear picture of the fund's ability to sustain its current distributions.
Finally, it is my hope that closed end fund managers and directors carefully consider whether a managed distribution plan is in the best interests of investors, both at the outset and during the life of the plan. I am aware that managed distribution plans may have a potential role in narrowing a discount to NAV. Fund managers should monitor whether such a narrowing is occurring when a managed distribution plan is in effect and report back to fund directors. In addition, fund managers should communicate with directors regarding whether distributions encompass a partial return of capital and whether appropriate steps have been taken to enable investors to properly appreciate the nature of their distributions.
In addition, management and fund directors should consider whether the current distribution rate is sustainable. If, for example, the distribution rate is higher than the total return that the fund can reasonably expect to generate, what will the long term consequences for shareholders be? If the funds assets are being depleted, will the expense ratio rise, impairing the fund's long-term performance? If it appears that the fund's current distribution rate is unsustainable, is it in the best interests of shareholders to reduce the distribution rate gradually?
There is certainly more that can be said on this subject, and I leave a further discussion of these issues to the Distribution Policies panel that will close the conference later today. However, I do want to emphasize that closed end fund innovation is an important goal. Meeting the needs of investors, including their desire for regular income, is also an important goal. My Division will not unnecessarily stand in the way of these goals. However, product development must be pursued responsibly and with investors' interests at the fore, if the closed end fund industry is to maintain the trust and confidence of its investors. Marketing alone should not drive product development — the ultimate motivators should be the needs and best interests of investors.
IV. The Disclosure Regime for Closed End Funds
Speaking of the best interests of investors, I would now like to turn my focus to the fund disclosure documents and other information currently available to closed end fund investors. As you may have heard, a major policy priority for the Division of Investment Management this fall is a recommendation to the Commission to propose an enhanced mutual fund disclosure regime that would focus on the so-called "layering" of disclosure. The centerpiece of the proposal would be a new two-page summary prospectus that would contain key information about a mutual fund, including the fund's objectives, investment techniques, fees and performance. Additional, more detailed information would be available on line, or in paper upon request, for those who want it. In addition, the Commission has launched an interactive data voluntary filing program for mutual funds, using an interactive data taxonomy developed by the ICI. Interactive data can greatly enhance an investor's ability to use the information currently available and perform research and comparisons based on areas of personal preference and interest.
I am interested in whether we can make similar strides in the disclosure regime applicable to closed end funds. Of course, the closed end fund disclosure regime is very different than the regime for mutual funds. Specifically, in the closed end fund context, annual and semi-annual reports and especially the annual proxy statement and shareholder meeting are key ways by which investor communications occur. On the other hand, the mutual fund disclosure regime is heavily reliant on fund prospectuses.
As in the mutual fund regime, however, I expect that there are ways we can make better use of the internet and other technologies to enhance the dissemination of information to closed end fund investors. Furthermore, I believe that less may be more when it comes to certain types of disclosures. I also believe that closed end fund investors may benefit from a concerted effort to streamline documents. In this way, investors can focus on key information without all of the "legalese" and other "noise" that, at best, can become a distraction and, at worst, can distort meaning. If the disclosure the Commission currently mandates ends up in the trashcan before being read, then we need to re-consider our mandates and our disclosure regime. Disclosure that does not communicate serves no one's interest.
I therefore welcome your thoughts and suggestions regarding how the closed end fund disclosure regime could be improved — whether through interactive data, enhanced use of technology, revised SEC requirements or otherwise. As I indicated, my Division's current focus is the reform of mutual fund disclosure, but it is not too early to consider expanding our reform efforts to one day encompass closed end funds.
I have discussed my concerns regarding valuation and product development, as well as my hopes for the future of closed end fund disclosure. However, before ending my remarks, I want to take a moment to acknowledge the important role that closed end funds fill in the retail investment landscape. Closed end funds provide investors with access to certain securities markets and investment techniques that would not be appropriate in the mutual fund context, because of the daily redemption requirement. In addition, closed end funds enable retail investors to have access to skilled, professional asset managers with expertise in sophisticated investment instruments. Many investors have benefited significantly from their investments in closed end funds. In addition, many of these investors have used closed end funds to diversify their personal portfolios and gain exposure to otherwise difficult to access markets.
It is my hope that the closed end fund industry will continue to serve as a positive force and resource for America's investors. It is my further hope that the Division of Investment Management can continue to develop and refine recommendations for the closed end fund regulatory regime for the optimum benefit of closed end fund investors.
Thank you very much for listening to me, and I hope you enjoy the remainder of the conference.