The Vanguard Group
February 6, 2004
Jonathan G. Katz, Secretary
RE: Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings; File No. S7-26-03
Dear Mr. Katz:
The Vanguard Group1 appreciates the opportunity to comment on the Securities and Exchange Commission's proposed reforms to mutual fund disclosure requirements concerning market timing, fair value pricing, and selective disclosure of portfolio holdings.2 Vanguard strongly supports this important initiative, which is aimed squarely at shedding light on how well mutual funds protect their investors from certain abusive practices that have dominated recent business headlines.
In our view, the Commission's proposal generally is well tailored to its goal. However, we do have some concerns. First, the requirement to describe with specificity a fund's policies and procedures for deterring market timers could be interpreted to deprive funds of much needed flexibility in the way that they deal with market timing issues.3 Second, the requirement to describe a fund's policies and procedures for detecting market timers could actually thwart funds' efforts to protect their investors.4 Each of these comments is discussed more fully below.
In addition, we agree strongly with the comments of the Investment Company Institute submitted in response to the Release and urge the Commission to adopt the Institute's recommendations. Although we do not find it necessary to restate those comments here, we believe they contain important refinements to the Commission's proposals. We have elected to write separately on the issue of market timing disclosures because of our long-standing interest in combating market timing, and our ability to draw on decades of experience in developing and disclosing policies to detect and deter these practices that may harm fund shareholders.
1. Policies and Procedure For Deterring Market Timers
Under the proposal, a fund's prospectus would be required to describe with specificity any policies, procedures, or restrictions adopted by the fund's board of directors for deterring market timing activity. A fund's prospectus also would be required to describe with specificity any circumstances under which its restrictions on market timing will not be imposed.
Vanguard funds vigorously discourage market timers through a variety of policies, procedures and restrictions. Vanguard funds' prospectuses and Statements of Additional Information have provided detailed disclosure about our anti-market timing efforts for many years, and we consider this disclosure essential, with or without an SEC rule specifically requiring it. Our deterrence disclosure serves at least two critical purposes. First, we hope that this disclosure immediately and completely dissuades frequent traders from ever investing in the Vanguard funds in the first place. Second, we want investors to be aware of our policies, procedures and restrictions affecting purchases, redemptions and exchanges, so that they can plan their transactions accordingly.
In the wake of the widespread reports of certain funds selectively permitting market timing by favored investors, we believe that it is right for the Commission to require all funds to disclose whether they discourage market timing, and, if so, what tools the fund uses. Investors deserve to know whether and how funds seek to deter market timing, and whether and what exceptions may exist to a fund's standard restrictions on market timing. However, there is a danger that the proposal's requirement for specificity in a fund's disclosure could be interpreted to deprive funds of much needed flexibility in administering their market timing deterrence programs.
In some cases, a fund may want to apply more rigorous policies, procedures or restrictions than those specifically disclosed in its prospectus. For instance, funds sometimes receive information from financial intermediaries about investors who have repeatedly violated other fund companies' market timing policies. In order to protect the interests of long-term investors, it may make sense to condition future exchange activity on these individuals' willingness to abide by special transaction rules that go beyond the fund's prospectus disclosure (e.g., all exchanges must be requested in writing, redemption proceeds will be paid in-kind if shares are held for less than a specified time period, or all exchange transactions must be spaced at least six months apart.) Similarly, it may make sense for a fund to impose stricter transaction rules preemptively if an investor has abused or sought to abuse the market timing policies of other funds within the same fund complex. In either case, the special transaction rules would be tailored to the situation at hand, and it may not be practical or productive to disclose all potential scenarios in a fund's prospectus.
In light of this concern about how the proposal's requirements may be interpreted, we urge the Commission to make clear that a fund's management may: (1) reserve the general right to apply more rigorous market timing policies, procedures, and restrictions than those disclosed in a fund's prospectus; (2) exercise reasonable judgment in applying their disclosed policies, procedures and restrictions on market timing; and (3) reserve the general right to revise such policies, procedures and restrictions as circumstances change. To the extent the Commission is concerned that enhanced discretion could lead to inappropriate exceptions to the anti-timing policies, we believe the recently adopted compliance rule effectively closes the door to that potential abuse.5
2. Policies and Procedures for Detecting Market Timers
Under the proposal, a fund's prospectus would be required to describe any policies and procedures adopted by the fund's board of directors for detecting market timing activity, including any arrangements for detecting such activity through intermediaries, such as investment advisers, broker-dealers, transfer agents, and third party administrators.
As a leading provider of index funds and international funds, Vanguard has accumulated substantial experience in trying to detect market timers and bar them from our funds. Market timers have long viewed index and international funds as attractive targets that can be exploited readily through quick, in-and-out trades. Many market timers shun Vanguard funds rather than play by our rules limiting frequent in-and-out transactions. However, other market timers work very hard at crafting ways to get around the rules. Requiring funds to disclose their policies and procedures for detecting market timers would only make that work a lot easier. Perversely, it would give market timers just the road map they need for circumventing and, therefore, effectively disabling, a fund's policies and procedures intended to deter their harmful practices.
Unfortunately for funds' long-term investors, published reports about market timing abuses have already shone a spotlight on several common ways in which market timers seek to avoid a fund's detection measures.6 For instance, it is now public knowledge that many funds screen exchange transactions over a specified dollar amount, and that market timers sometimes can avoid detection by breaking a single transaction into two or more smaller transactions. It is also now public knowledge that market timers may be able to camouflage their activity by transacting through multiple account registrations or multiple financial intermediaries.
Although the proposed disclosure requirement would give market timers a further leg up on their efforts to avoid detection, it would provide other investors with little information of genuine use.7 Without reasonably intimate knowledge of a particular fund's transfer agency operations, the typical investor simply would be in no position to judge whether a fund's stated detection procedures are likely to be effective or not. We believe that judgment is best reserved for the fund's board of directors.
We further believe that there is a better way to let investors know whether a fund has meaningful policies and procedures to detect market timing. Specifically, the Commission could require a fund to disclose: (1) whether its board of directors has adopted policies and procedures for detecting transactions that may violate its policies and procedures on frequent purchases, redemptions, and exchanges; and (2) whether its board of directors has determined that such detection policies and procedures are reasonably designed to accomplish their objective.8 As a related and very important point, we urge the Commission to recognize that even "reasonably designed" detection policies and procedures cannot guarantee that a fund's policies, procedures, and restrictions will catch every market timer. By acknowledging this in the adopting release, the Commission will encourage funds with long-term investment strategies to develop the most effective policies possible. Otherwise, we fear that some companies will opt to loosen their policies out of a concern that they cannot guarantee that their disclosed procedures will prevent every clever market timer from evading detection.
We appreciate the opportunity to comment. If you would like to discuss these comments further, or if you have any questions, please feel free to contact me, or Christopher Wightman, Associate Counsel.
cc: Paul F. Roye, Director
John J. Brennan, Chairman and CEO