Speech by SEC Staff:
Keynote Address at the Practising Law Institute's Investment Management Institute 2009
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, New York
April 2, 2009
Good morning and thank you for the kind introduction. It is a pleasure to be here with you today. Before I begin, it is my obligation 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 Commission staff.
I always enjoy participating in this conference as it provides an opportunity to discuss and examine the regulations and potential regulations that are the focus of our work in the Division of Investment Management. I am particularly excited to engage in this discussion with this year's tremendous faculty, which includes three former Directors of the Division — Joel Goldberg and our two conference co-hosts Barry Barbash and Paul Roye. I am honored to participate on the first panel of the conference with each of them and appreciate their wisdom and perspective in these interesting and challenging times.
The insight of my predecessors, along with the other very knowledgeable panelists at today's conference, is especially valuable during this period in which we are re-evaluating the current regulatory framework governing investment companies and investment advisers at every level. At the most fundamental level, there are calls for wholesale changes to the financial regulatory landscape, such as the suggestion for the creation of a governmental regime for managing systemic risk throughout our markets, and suggestions of possible streamlining of the system of multiple financial regulators. There are also legislative proposals aimed at strengthening the statutes governing the various aspects of financial regulation, including the Investment Company Act.
At the Commission, and specifically in the Division of Investment Management, we have been in a period of tremendous change. Notably, in 2008, the Commission adopted a number of far-reaching initiatives. One of the most significant of which was the adoption of a Summary Prospectus. This initiative represents revolutionary reform in mutual fund disclosure with the provision of key information to fund investors in a user-friendly format. The Commission also adopted rules related to interactive data and indexed annuities. In addition to having adopted rules, the Commission proposed regulations related to Regulation S-P privacy issues, references to credit rating agencies in Commission rules, investment adviser disclosure in Form ADV, and also proposed Commission guidance on board oversight of soft dollars and execution of fund portfolio transactions. Furthermore, the Commission proposed a rule that would permit exchange-traded funds to come to market without first obtaining a Commission order.
In addition, the Division continues to review and work towards modernizing the fund and adviser regulations that may have become outdated or less effective. In this regard, we are working on recommendations for the Commission in such areas as books and records requirements for funds and advisers, shareholder report reform, adviser custody rules and guidance to fund directors with respect to valuation of fund securities.
During the next panel, and over the course of the next two days, much of the discussion will focus on the regulatory initiatives in the investment management area, so I won't get into the details on these initiatives now. What I would like to talk about instead is how some funds have performed in the current environment and some of the experiences fund investors have had over the course of the last year.
2008 was a particularly difficult year for America's investors. The Dow and S&P 500 both fell more than 30 percent, their worst performance since the 1930s. The NASDAQ fell slightly more than 40 percent, its largest decline ever. International stock markets fared no better. Municipal, corporate and asset backed debt securities indices registered losses ranging from 5 to 30 percent. Only US Treasury securities showed positive returns for the year. Some have noted that we are in the worst financial crisis since the Great Depression.
Investors in investment companies have also been affected. The average growth fund lost more than 40 percent, the average value fund more than 35 percent, the average corporate bond fund almost 5 percent and the average high yield municipal fund more than 25 percent.
As disappointing as the results are for investment company investors, they are not surprising considering the performance of the underlying markets. What is surprising though are some of the investment results investors have experienced with respect to certain investment products, and that is where I would like to focus my attention today.
The mutual fund industry is one that approximately 92 million investors have entrusted over 9 trillion dollars to. The over 8000 funds in which this money is invested cover a wide range of investment objectives, asset classes and strategies. It is to be expected that the performance of individual funds will, quite naturally, differ. What has been surprising, however, has been how wide the difference has been. For example, in the bond fund area, while the average high yield bond fund lost 26 percent on average, the range of performance was plus 7 percent to minus 78 percent. Similarly, with national tax-exempt bond funds, while the average fund lost almost 7 percent, the range in performance was from plus 6 percent to minus 49 percent. Now these are just a few examples but they illustrate a real challenge to the industry and to American investors. At a time when some 70 percent of actively managed funds underperform their benchmarks, if an investor or an investment adviser can not accurately identify who might outperform, what is the value proposition in taking on the risk for this variance in performance?
We have also witnessed some trendy investment products through the years. We witnessed the option income and government plus funds in the late 80s, and early 90s. We saw the short-term world income funds in the 90s. These latter funds were presented to investors as low-risk, high-yield alternatives to money market funds. However, investors were caught off-guard when these funds' carefully constructed currency hedging strategies went awry. We also had, of course, the tech funds. The enhanced cash funds at the beginning of this decade also should not be forgotten. I could go on, but I am sure you get my point — these funds were trendy investment products that did not perform for investors as well as the investors, and the funds' creators, expected.
Investment companies have become the investment vehicle of choice for America's investors over the years because of their value added. The development of new products that are marketed to investors should not be about what you can sell but rather about what you should sell to investors. In my view, funds should be built on sound principles and designed for investing for the long term, not to capture assets based on short term trends. Also, risks assumed by investors should be related to the markets and asset classes that they invest in.
This brings to mind some current trends I find worrisome. I am concerned about the increasing use of leverage by funds. While sophisticated investors might have the ability to properly evaluate the impact of employing leverage in funds, I question whether many retail investors can. Indeed, a fund that sought to provide a return of 200% of an index on a daily basis, apparently did so but the result in the long term was, I believe, quite disappointing. The index was down about 6 percent, and the fund, seeking 200% of that return daily, was down over 21 percent. For a longer period the index was up 50 percent yet the leveraged fund was actually down over 20 percent. That is correct, the index was up 50 percent and the leveraged fund was down 20 percent. Now, I suspect all the disclosures were there and the fund did what it said it would, but who would expect that result. This is just one example. We have seen other extreme cases of unexpected losses in funds that were tied to high-risk investment in subprime mortgage securities and credit-default swaps. One such fund declined more than 80 percent in value by the end of 2008.
Now I don't want to suggest that I believe the SEC should be a merit regulator. Funds that fully comply with the requirements of the securities laws, including the Investment Company Act, and which provide full disclosure to investors are not held up by my Division. Nor should they be. I am also not of the view that my Division can necessarily discern a good or bad investment product any better than the firms can. I am, however, challenging the investment company industry to take this issue seriously. Not all innovation or ingenuity is positive.
Now let's turn to some innovation that has been positive.
Money Market Funds
First, money market funds have been one of the most important innovations within the mutual fund industry. In the 1970s, money market funds served as the vehicle that essentially introduced many investors to the mutual fund industry. Between 1974 and 1982 the total assets held in money market funds grew from less than $2 billion to over $200 billion, accounting for three-fourths of the mutual fund industry's assets. Currently, with almost $4 trillion in assets, money market funds are of fundamental importance to the financial system as they serve to meet the liquidity and capital preservation needs of all types of investors — both individual and institutional by maintaining a stable net asset value of $1.00.
While money market funds are an innovative product that provided a great benefit to the fund investors, events of the past eighteen months have presented a challenge to the traditional money market fund model.
Money market funds began experiencing difficulties in the fall of 2007 when problems in the residential home mortgage market first affected money market funds' holdings of commercial paper issued by "structured investment vehicles," or SIVs. While most SIVs had little exposure to sub-prime mortgages, investors began to avoid asset-backed commercial paper. This caused the value of the commercial paper to fall and threatened to force certain money market funds to "break the buck." No money market funds broke the buck as a result of this exposure, however, because either SIV sponsors supported troubled SIVs or money market fund affiliates supported the affected funds.
However, in September of 2008 during a period of extreme tightening of the credit markets we saw the first "breaking of the buck" by a widely-held money market fund. It is gratifying to note that in the wake of adverse market conditions of September 2008, many intervened in the money market arena swiftly, dealing with such adversity for the greater good of investors and the market. Specifically, many money market fund sponsors or their parent firms were willing to voluntarily step in and assist money market funds facing credit or liquidity challenges by entering into asset purchase or credit support arrangements benefiting fund investors.
Furthermore, money market funds have also had to address the challenges posed by low or non-existent yields in treasury securities — in fact, we have been seeing the lowest yields on Treasuries in 50 years. These low yields are driven by the flight to quality as institutions increasingly move into U.S. government money market funds. As some portfolio securities mature and these funds purchase new treasuries with new money the yield is diluted even further. As a result we have seen a number of treasury money market funds close to new investors and we understand funds have waived fees and expenses in order to avoid negative yields.
As a result of these events, the Commission staff and the primary industry trade association for money market funds, the Investment Company Institute, have stated the need to review the current money market fund model in light of investor protection concerns that have emerged. Money market funds' twin goals of providing liquidity, typically on a same-day basis, and preserving capital at times can conflict. And in times of severe market turmoil, the twin goals may not be able to be achieved simultaneously. As an example, when liquidity is at a premium, spreads may widen considerably, thus making it more difficult to sell even the highest quality instruments at or near "amortized cost." On the other hand, a desire to maintain a $1.00 NAV can cause a fund to seek to delay redemptions or the payment of redemptions and thus fail to meet fund shareholders' expectations of liquidity.
Many assert that the stable $1.00 NAV has been important to the development and popularity of money market funds. While the popularity of the stable $1.00 NAV is understandable, it does present certain potential drawbacks to investors.
First, the choice of $1.00 instead of $10.00 per share NAV has made the NAV quite insensitive to losses and gains in the funds' portfolios until, once they reach 0.5%, the share price rises or falls a full 1.0%. That means that while price changes can be expected to be infrequent, when they do occur, they will be fairly dramatic.
Second, this lack of sensitivity to volatility affords investors, particularly large investors, the opportunity to take advantage of the fund and its other shareholders. An example might be helpful here. Assume a money market fund has a loss on investments of 0.40% so that its NAV is now $0.9960, which is $1.00 and within the one-half percent deviation permitted under current rules. If investors who own 25% of the fund redeem at $1.00, the NAV is now $0.9947 or $0.99 per share. Sophisticated investors know this dynamic and will redeem their shares in the fund quickly, leaving the loss for the remaining shareholders. What had been a loss of 40 cents on $100.00 for remaining shareholders is now $1.00 on $100.00 because they did not abandon the fund quickly enough. I question whether this is appropriate and whether it increases the possibility and probability of a run on a money fund.
Third, the $1.00 price may not provide investors with adequate information regarding their investment. As with the previous example, an investor purchasing at $1.00 when the NAV was $0.996 had no way to know that he (she) was at risk of losing 1% in one day merely because of redemptions by others or other minor valuation moves. These problems could be addressed by the adoption of a $10.00 NAV or a floating NAV. I believe these important issues must be considered when approaching money market fund reform.
As the review of the money market fund model and its regulatory regime is one of our top priorities in the Division of Investment Management this year, the staff is exploring these issues and we look forward to pursuing this area of reform in cooperation with the fund industry and fund investors. We share the common goal of conducting a wholesale review of the money market fund model, its attributes and the regulatory requirements applicable to it. The Division will recommend that the Commission update those regulatory requirements where and as necessary. I further expect that this endeavor will be guided by the fundamental principle that the money market fund model and its regulation should be tailored to best meet the liquidity and capital preservation needs of fund investors. In this regard, I appreciate the work the mutual fund industry has performed in this area through the Investment Company Institute's Money Market Working Group. The Working Group published a comprehensive report last month outlining its recommendations in developing changes to the money market fund model. I view this as a good first step towards real reform in this area. I look forward to quickly developing recommendations for changes to protect money market investors.
Finally, I briefly want to discuss developments in another area exemplifying the benefits of innovation within the investment management industry, and that is exchange-traded funds, or "ETFs". ETFs have become a popular and important financial component of our financial markets since the launch of the first ETF, SPDRs, in 1993. Because of their unique structure, ETFs must obtain exemptive orders under the Investment Company Act before they can operate. The Commission has issued about 70 of these orders, and the ETF marketplace has grown to approximately 680 ETFs with a total of about $400 billion in assets.
The growth and development of ETFs over the past sixteen years continues to be marked by innovation. As the industry has progressed, we have seen changes in format and organization, as well as in the types of indices underlying index-based ETFs. Today, ETFs include both domestic and international equity ETFs, fixed-income ETFs, target date ETFs, and ETFs of ETFs, among others. The Commission has issued orders to permit the operations of leveraged ETFs, and last year, the Commission issued the first orders to allow actively managed ETFs with fully transparent portfolios. The Division has received some applications for actively managed ETFs with non-transparent portfolios, although none has been approved to date. As ETFs have evolved, the regulation of these products also has evolved. Since becoming an important component within our markets, and with investors and regulators becoming accustomed to them, ETFs with comparable characteristics are able to be introduced with less regulatory review prior to their launch. Accordingly, in March of last year, the Commission proposed new rules relating to ETFs that would permit ETFs to come to market without first obtaining a Commission order.
I want to thank you for listening this morning. We are entering a new era in financial services, and the investment company industry — an era of broad-sweeping regulatory and industry changes. I am sure you will find the next two days highly stimulating and enjoyable as you discuss these developments. With the innovative nature of the fund industry, it also will be interesting to watch it evolve and adapt to this new environment. With a continued investor-focus that has been the hallmark of the industry's success, I am confident that mutual funds will maintain their role as the premier investment products of America's average investors. Thank you again and enjoy the conference.