Looking at Funds through the Right Glasses

Thank you, Susan Olson, for that kind introduction.  I appreciate the invitation from the Investment Company Institute and the Federal Bar Association to deliver remarks this afternoon. It is particularly fitting that my first speech as a Commissioner is here at a conference dealing with issues related to mutual funds and other investment companies. I first came to the Securities and Exchange Commission (“Commission”) in 2000 when I joined the Office of Regulatory Policy in the Division of Investment Management. Working on issues related to mutual funds is how I spent my early years at the Commission, and improving fund regulation remains one of the most important issues for me.

As you all know, more than 95 million people in the US own funds, and US registered investment companies manage more than $19 trillion in assets.[1] Mutual funds play an important role in Americans’ retirement planning, particularly for American workers. Over $7.5 trillion in retirement savings are invested in mutual funds.[2] Assets in Section 529 savings plans increased nine percent in 2016 and now make up more than $250 billion in assets.[3] Workers rely on the expertise of the investment advisers to these funds to ensure that they will have the means to live out their lives with dignity and enjoy their retirement years. Families rely on the expert management provided by funds to ensure, among other things, that they will have the ability to pay for their children’s college education and their own retirements.

We owe it to the many Americans for whom funds play such an important role to take a step back and examine our regulatory regime for funds. Before I continue, I need to provide the standard disclaimer that the views I express today are my own and do not necessarily reflect those of the Commission or my fellow Commissioners.

The last time I was in San Antonio, I was twelve or thirteen years old. I had come from my hometown of Cleveland, Ohio to run a cross country race. I remember the drive from the airport in Houston and visiting the Alamo, but I don’t remember anything about the race, which probably means that I didn’t run very well. One factor in some of my poor performances was that I preferred to run without glasses, and I didn’t have contacts. Not surprisingly, there was more than one time that I got lost on an unfamiliar cross country course. You walk part of the course in advance to get an idea of where you are going, but it really helps to see the markers along the way as you are running the race. Finally, after one too many wrong-turn races, an annoyed coach ordered me to wear my glasses. Lo, and behold, I stopped getting lost, which greatly improved my race times. The SEC too is hampered when it runs without its glasses. Let me give you a few examples of ways in which we could improve our regulatory performance by sharpening our vision.

I. Seeing the Cost Big Picture

The SEC often wears blinders when it comes to cost assessment. We tend to underestimate the costs of individual rule changes. The costs incurred by funds in complying with our rules overwhelmingly come out of investors’ pockets. Depending on the competitive landscape, fund advisers may cover a fraction of the expenses, but typically the costs are covered by fund assets and fund assets are investors’ assets. Even if we get the cost assessment right on an individual rule, we rarely think about aggregate costs resulting from the cumulative regulatory burden. More is not necessarily better in regulation.

Investors pay in ways other than direct expenditures on compliance. In addition to the monetary costs of our regulations, we also must consider the time burden associated with our rules. The reason for funds’ existence is to manage investors’ assets with an eye toward generating a return. The time consumed trying to comply with the rules translates into less time available to manage investors’ assets. Nowhere is this more evident than in all of the regulatory obligations faced by boards. Board books keep getting thicker and board agendas focus increasingly on compliance, rather than on the primary business of the funds—making money for investors. We need to let boards get back to their core functions.

The volume and cost of fund regulation also act as a barrier to the entrance of new fund sponsors. While existing fund complexes continue to add to their offering menus, potential new fund sponsors are unable to meet the costs associated with entering the fund industry. Investors lose when new competitors can’t come in to serve them.

Another cost comes in the form of lost returns. As we place restrictions on what funds can do, we also make it harder for them to achieve returns for investors. Careful scrutiny of costs and benefits before adopting rules helps to ensure that investors are protected and able to achieve their reasonable investment objectives.

Yet another too-often-ignored effect of our rules is the substitution of the Commission’s investment judgment for that of investors and investment advisers. Our rules can have the effect of prejudging what is right for investors. In other words, they shut off some options for investors. We must be exceedingly careful in taking steps that substitute our judgment for the judgment of investors.

II. Retrospective Review of Fund Regulations

Once a rule is in place, the SEC should not stop looking at costs and benefits. As is typical of most regulatory agencies, the SEC rarely puts on its hindsight glasses. In many ways, the dearth of retrospective review is not surprising. We face a constant stream of new regulatory challenges, so looking back at how well we have dealt with old ones is not at the top of anyone’s list. Nevertheless, perhaps the most important action the Commission can take to improve fund regulation is to conduct a retrospective review of our regulations to see whether they, individually and collectively, accomplish what they were designed to do.

We need to look at the actual cost—based on experience—of each regulation. If a rule’s costs outweigh its benefits, we should eliminate it and, if necessary, replace it with something more cost-effective. We need to consider the aggregate costs of our regulations, which entails looking at how regulations interact with one another.

The retrospective review exercise is more than simply a numbers game. Retrospective review involves thinking back to the problem we were trying to solve when we put a regulation in place. We need to ask whether the regulation has stood the test of time. Is it accomplishing the intended objective? Is it causing unintended harm or generating unanticipated benefits?

Retrospective review typically occurs after a rule is already in effect, but the Commission currently has a rare opportunity to review a rule before it takes full effect. I am referring to rule 22e-4, which we adopted under the Investment Company Act of 1940 in October 2016 to address fund liquidity.[4] Since then, we have learned that the liquidity classification requirement in the rule, commonly referred to as “bucketing,” is a much tougher implementation project than anticipated and that the role for third-party service providers is going to be more extensive than we had originally understood.[5] Among other problems, the rule is insufficiently flexible to accommodate different types of funds and requires numerous difficult judgment calls.

In response to what we learned, we issued an interim final rule extending the bucketing compliance date by six months.[6] At the same time, Commission staff released a set of Frequently Asked Questions, the length of which underscores the emerging complexity of the bucketing requirement. The interim final rule release also indicated that more interpretations likely are coming.[7] Indeed, I have heard from funds that the FAQs, while helpful, prompted a new set of questions. Clearly, the liquidity classification requirement is proving to be much more burdensome than the Commission thought at the time it was adopted.

Last week, we again addressed issues dealing with funds’ liquidity classification. We issued a proposing release that included changes to the information required on Form N-PORT and Form N-1A regarding funds’ liquidity classification.[8] The Commission proposed to rescind the requirement that open-end funds publicly disclose aggregate liquidity classification information about their portfolios. We proposed that funds instead disclose information about the operation and effectiveness of funds’ liquidity risk management programs in their annual report to shareholders. In addition, all registrants would have to report on Form N-PORT their holdings of cash and cash equivalents. The proposed amendments to Form N-PORT also would allow funds to classify the liquidity of their investments in multiple liquidity classification categories for a single position under certain circumstances.

These changes are positive, but the bucketing elephant is still very much in the room. We did not take the opportunity last week to ask whether we should eliminate the bucketing requirement altogether. We gave only a slight nod to the idea suggested by the Department of Treasury, that we look for a principles-based alternative to bucketing.[9] In light of the proposed changes—the proposed qualitative liquidity disclosure and the proposed N-PORT cash and cash equivalents disclosure—and the additional complexities the Commission has witnessed since adoption of the bucketing requirement, wouldn’t it make sense to ask for comment on whether bucketing remains a meaningful requirement? The proposed requirement that registrants disclose their cash and cash equivalents on Form N-PORT, when combined with our other requirements, might be a more efficient and effective alternative to the liquidity classification requirement.[10]

The bucketing information provided to the Commission will not be comparable across funds and may not even be comparable within the same fund. It is not, therefore, clear to me that the bucketing data will be useful to the Commission.[11] The information might be interesting to the Commission staff, but I don’t get the sense that it will be particularly useful in monitoring fund activity. Even assuming that we would find some benefit in the bucketing information, for us to retain the requirement, the benefit must outweigh the one-time and ongoing costs to funds in terms of money, time, and opportunity costs.

Failing to ask now—prior to full implementation—whether the benefits outweigh the costs virtually ensures that the bucketing requirement, as so many requirements before it, will become an everlasting fixture of our regulatory regime and another barrier to entry for new fund sponsors. For the Commission, funds’ liquidity risk management programs, funds’ qualitative liquidity disclosure, disclosure of their portfolio holdings (as will be required by Form N-PORT), identification of the holdings funds consider illiquid, the 15 percent limit on illiquid investments, and disclosure of funds’ cash and cash equivalents likely provide sufficient information for an evaluation of fund liquidity. Yet we are not even asking whether bucketing remains necessary.

To make matters worse, the proposal foreshadows future “public dissemination of [granular] fund-specific liquidity classification information.”[12] This idea, one we rejected when we adopted the bucketing rule[13] and one I opposed adding to this release, fits rather awkwardly in a proposal to eliminate public disclosure of aggregate fund-level information because it is useless and potentially misleading to investors.

I have heard from some fund sponsors that they view the bucketing chapter as closed. Lots of money already has been spent, so why stop now? The would-be economist in me cringes at such logic. In any case, my responsibility to investors requires me not to close my eyes to the way bucketing is playing out, but to keep asking questions. After all, investors are the ones who will pay, whether through higher fees or lower returns, for ill-conceived liquidity regulations.

III. International Shaping of US Regulatory Policy

The Commission undertook its fund liquidity rulemaking under pressure from the Financial Stability Oversight Council (“FSOC”) and the Financial Stability Board (“FSB”), both of which view fund liquidity as a potential systemic risk.[14] The Commission ought not to put on glasses that contain the distortive lenses favored by our international banking regulator friends. Funds are not banks and should not be regulated as if they were.

I recognize that if the Commission proposed to eliminate the bucketing requirement or even to modify it to allow for a principles-based approach, international regulatory bodies might seek to incorporate a bucketing system into recommendations or standards. Such tactics have been used in the past. Given the changes that we proposed earlier this month—the cash and cash equivalents disclosure coupled with a qualitative liquidity risk management program disclosure—we stand on strong ground to argue in response that we have addressed liquidity issues in a form that is appropriate for funds.

Fund liquidity is only one of many subjects that together spawn volumes of principles, standards, recommendations, and guidance promulgated by international organizations, particularly the FSB and the International Organization of Securities Commissions (“IOSCO”). The Walgreens located next door to the SEC ought to stock up on reading glasses, if it has not done so already, to outfit the many pairs of SEC eyes worn down by these international documents. I cannot even begin to name all of the FSB and IOSCO work streams, working groups, and committees, let alone what each one does. It’s not only the volume, but also the substance that has me worried.

An example of this overreach painfully familiar to everyone here was the FSB’s attempt in the wake of the 2007-2009 global financial crisis to extend banking regulations to non-banks, including funds, by designating certain non-bank financial institutions as global systemically important financial institutions (“G-SIFIs”). A G-SIFI designation paved the road to prudential regulatory supervision and oversight. Such attempts to fundamentally change regulation in a way that in turn would change the entities being regulated have serious implications for American investors.

International organizations, of course, play an important role in fostering effective regulation and supervision. It is a role to which I am committed. These groups provide a framework within which countries assist one another in enforcement and oversight efforts. Many of the Commission’s investigation and enforcement efforts have an international component, so such cooperation is essential. International organizations also can help to encourage technical training initiatives, which build relationships among regulators from different parts of the world. International organizations also play an important role in bringing together supervisors, who can share perspectives on firms operating across borders and compare notes on how they approach regulatory and supervisory challenges. International organizations can document different regulatory approaches in different countries, which other securities regulators may find informative in tailoring their regulations to the particular characteristics and circumstances present in their own securities markets.

Building strong relationships in times of relative calm in the financial markets is essential. Writing countless pages of reports is not. That brings me to the topic of disclosure—another area where we have sometimes allowed volume to be a measure of success.

IV. Fund Disclosure

Many of you probably purchased special glasses to watch last year’s solar eclipse. The filters in those glasses enabled scores of people to watch the solar eclipse without damaging their eyes. The pinhole viewers of the past gave way to this new technology. The Commission likewise has the opportunity to use technology to enable investors to get more out of fund disclosures. I hope to be able to work toward this end during my tenure at the SEC.

Moving forward with rule 30e-3 would be a first step. In 2015, the Commission proposed to allow website transmission of fund shareholder reports. Rule 30e-3 was the one component of the reporting modernization proposal that promised a reduction in costs for fund shareholders. While the rest of the data modernization package was adopted in 2016, rule 30e-3 was not. For me, it is about more than saving fund investors money—although that is important. It is about facilitating a larger effort of harnessing technology to provide investors with information in a way that they can better understand and analyze.

That effort also will require us to revisit other disclosure rules with an eye toward providing investors with what they need, rather than what a bevy of Washington lawyers thinks they ought to read. Practical reality—i.e., legal risk—means that we will always have lots of disclosure. Nevertheless, I hope that we can make real progress on creating documents that are investor friendly. The Commission should amend our disclosure requirements to reflect the information that investors consider important in making their investment decisions and present it in an easily accessible, readable, layered format.

One positive contribution in the otherwise disappointing Dodd-Frank Act is section 912, which allows the Commission to undertake temporary investor testing programs. [15] The Commission should use this authority to devise creative approaches for getting investors the information they need in a format they want to use.

The Commission got off to a good start on revamping fund disclosures with its adoption of the mutual fund summary prospectus.[16] A similar variable annuity summary prospectus would be a valuable project. The Commission also should consider tackling shareholder reports. In all of these initiatives, we ought to be thinking about how new technology can assist investors in viewing with greater focus and—dare I say, greater enjoyment—the information they need to make their fund investment decisions.

V. Exchange-Traded Funds

I’ve talked a lot about glasses, but the Commission also needs to come to terms with its version of contact lenses—the exchange-traded fund (“ETF”). For years, ETFs have been operating under exemptive orders, rather than pursuant to a rule. Because of that, they are second-class citizens in the fund regulatory world. As all of you know, ETFs are more than a passing fad—they are here to stay. An article was posted to SSRN last week by University of Texas law professor Henry Hu and coauthor John Morley explained the problem as follows:

ETF regulation spills haphazardly from an odd mix of stock exchange listing rules and a motley group of statutes designed for older, fundamentally different products. . . . Appropriate ETF regulation is so lacking that the SEC has managed to hold it together only through the system of improvisatory, ad hoc administrative review at the moment of each new fund’s creation. This regulatory state of affairs causes two basic problems: first, it introduces pathologies in the process of regulatory administration, and second, it fails to address the ETF phenomenon’s most distinctive characteristics.[17]

The make-it-up as you go approach to regulation and the virtual absence of the commissioners from the process is a real concern to me.

Back in March 2008, the Commission recognized that ETFs “are an increasingly popular investment vehicle” and proposed an ETF rule that would have codified our ETF exemptive orders.[18] The Commission noted then that there were 601 ETFs holding $580 billion in assets.[19] The proposed rule would have streamlined the process for new ETFs coming to the market and would have subjected all ETFs to the same conditions for relief, rather than allowing some ETFs to operate under more favorable conditions than others.

Instead, the financial crisis hit and, as is known to happen in Washington, people got squeamish about possible criticisms that might accompany enactment of any exemptive rule. In the understandably timorous mood of the time, anything perceived as being deregulatory was identified as something that might lead to a future financial crisis. Crises are all about enacting onerous regulations on your wish list for which you would not find support in calmer times. The famous “you never let a serious crisis go to waste” mantra was not a call for finalizing the ETF rule.[20]

So, back to contact lenses. Contact lenses make many people—including me—squeamish. Glasses are a lot easier to put on and remove. They are familiar. Contact lenses, once viewed as “a novel and strange medical device,” made their way into common use and have revolutionized the lives of many people.[21] ETFs have done the same.

A decade after the ETF proposal, there are approximately $3.6 trillion in ETF assets.[22] Just as contact lenses were normalized, we need to normalize ETFs. That means adopting a carefully crafted rule that allows enough flexibility to accommodate a variety of models, while reserving the exemptive application process for ETFs with novel features in need of extra scrutiny. It also means working across divisions at the Commission to ensure that we address the full problem of regulation by one-off staff action.

VI. Conclusion

I call on all of you to help us at the Commission to put our glasses on (or our contacts). It is important that the Commission make sure that its fund regulatory framework is working efficiently and for the benefit of investors. A retrospective review of our regulations is long overdue. We need to pay particular attention to the collective costs and burdens of our regulations and the effect they have on funds’ ability to achieve what they were formed to do: provide a return on investments for millions of Americans so that they are able to provide for themselves and their families.

I am delighted that we have Dalia Blass, our Director of the Division of Investment Management, as a partner in this effort. As was evident from her remarks this morning, Dalia brings a wonderful enthusiasm to the Division’s work. She is committed to looking out for the interests of investors and works tirelessly to make sure not only that important issues are addressed expeditiously, but that the Commission gets the rules right. Dalia embraces difficult issues with a grace and determination that serves the American investor well.

As she noted, you are all a critical part of getting fund regulation right. Thank you for the opportunity to share my thoughts, and I am happy to take questions.