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Our Wish List for Fund Disclosure

How to improve turnover, expense ratios, and more.

Christine Benz, 11/27/2007

The Securities and Exchange Commission recently voted to require mutual funds to provide a streamlined prospectus that would give investors the skinny on a fund and facilitate quick comparisons--all in plain English.

Better disclosure has clearly been a priority for the commission under chairman Christopher Cox's leadership, and it's a laudable one. Too much fund literature is boilerplate text that makes investors' eyes glaze over. For example, fund companies throw everything but the kitchen sink into their prospectuses in an effort to stave off legal action in case they inadvertently do something they didn't say they would. And they write these passages in baffling, complex lawyer-speak. The end result of all that legalese, however, is that investors can read a prospectus but still not know what a fund does or how the manager intends to invest. Now that's a problem.

While the SEC is considering how to improve fund disclosure, we'd suggest they also consider adding or improving upon the following issues. (Note: Not all of these disclosures would fit within the streamlined prospectus; rather, some would be improvements upon already-required fund disclosures.) Fund companies needn't wait around for the SEC to act, either. Although a handful of these ideas, such as changing the turnover rate calculation, would hinge upon the SEC providing specific guidelines, these are generally shareholder-friendly disclosures that wouldn't be difficult for fund companies to adopt even without prompting from regulators.

Foreign-Currency Hedging Policy
Foreign-stock funds have trounced domestic over the past several years, fueled in large part by the appreciation of foreign currencies versus the greenback. Yet investors in foreign-stock funds would be hard-pressed to determine a fund's approach to foreign currencies and the extent to which currency maneuvers have contributed to a fund's gains. True, foreign funds' prospectuses tell you whether a manager is allowed to hedge (use futures contracts to increase or decrease the portfolio's exposure to foreign currencies), but they typically don't tell you whether the manager hedges all the time, none of the time, or opportunistically. And even though foreign funds' shareholder reports show you whether a portfolio included forward currency futures contracts, it's hard for a layperson to make sense of that information.

What about stating, in plain English, what the fund's currency positioning was as of the reporting period? Some fund firms, such as Oakmark and First Eagle, already provide brief but helpful comments on their current currency positioning in the managers' letters to shareholders. Others that hedge should follow suit. And all could tell shareholders how much--either in exact or approximate terms--of a foreign fund's performance in the reporting period owed to currency translation (and whether the hedging decisions helped or hurt the fund).

Tax Policy
As we've written before, one easy way to improve your take-home returns is to look for tax-efficient funds for your taxable accounts. Apart from municipal-bond funds and those that have "tax-managed" in their names, however, it's nearly impossible to tell a fund run by a tax-conscious manager from one whose manager doesn't give a whit about taxes. Over the years, we've noticed that managers really run the gamut on this front. Moreover, trying to glean tax efficiency from how tax-efficient a fund has been in the past is an unreliable and inexact science.

What about requiring funds to classify themselves in one of the following groupings? 1) Actively works to limit income and capital gains distributions, 2) pays some attention to limiting income and capital gains distributions, or 3) pays no attention to limiting income and capital gains. Of course, it might turn out that all funds would choose option 3 because it gives them the most leeway, but funds that chose options 1 or 2 would naturally be more appealing to investors looking for funds for their taxable accounts.

Improve Turnover-Rate Reporting
You often hear that you should look for low-turnover funds because such offerings tend to be more tax-efficient and have lower trading costs than faster-trading vehicles. Yet as Russ Kinnel noted in a commentary last year, turnover can be a highly misleading data point. That's because it doesn't encompass all of a fund's trading activities but rather looks at the lesser of a fund's purchases or sales over the past year, divided by assets. For a fund with big inflows whose manager has done nothing but buy buy buy, the fund's reported turnover could be close to zero even though the manager has been trading. The solution? Create a better turnover rate by adding purchases and sales together, then divide by assets.

Senior analyst Gregg Wolper has another suggestion for improving upon the current turnover disclosure. What about providing the extent to which the actual names in a portfolio have changed? After all, some managers trade frequently among their current list of holdings--adding or trimming opportunistically--even though they tend to stick with the same basket of stocks. Such trading is counted in a fund's turnover, but it's obviously quite different from a manager who completely up-ends his portfolio every few months.

Add Brokerage Charges to the Expense Ratio
While we're on the subject of existing disclosures that could be improved upon, I'll throw the expense ratio into the mix. Yes, the expense ratio is a great predictor of whether a fund will be a good or lousy investment--lower costs typically equal better returns. But the expense ratio could be even better if it also encompassed any brokerage commissions that a fund paid to execute its trades. After all, brokerage commissions--like a fund's management fee and administrative costs--are real, quantifiable costs that come out of shareholders' returns.

Those commissions are currently disclosed separately in a fund's Statement of Additional Information, but we'd like to see them calculated on a percentage-of-assets basis just like the expense ratio, then added to the expense ratio for a more complete view of a fund's all-in costs. True, even that improved-upon expense ratio wouldn't encompass a fund's complete trading costs, because market-impact costs--the extent to which the manager moves the price of the securities he or she is trying to sell--are also a factor. To help solve that problem, the SEC could require all-in trading-cost estimates using set criteria or based on estimates from third-party providers.

Improve Disclosure about Manager Compensation and Board Contract Review
Funds are required to disclose how the fund manager's compensation is structured so investors can tell if the managers' interests are aligned with their own. For example, a fund whose manager is compensated based on 1-year pretax performance is a poor fit for an investor seeking a long-term holding for a taxable account. However, fund companies provide varying levels of clarity on this topic, and the vast majority vague it up. This piece of disclosure would be much more powerful if fund companies were required to use more specific guidelines.

Similarly, fund boards are required to disclose the factors they look at when deciding to renew an advisor's contract. Here again, the language is typically vague boilerplate and not particularly helpful. We'd like to see more boards provide clear and concise language about why they renewed the advisor's contract, particularly when the management fee is high or when the current management team has underperformed for an extended period of time.

Christine Benz is Morningstar's director of mutual fund analysis.

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