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SEC Proposes an Overhaul of Fund Disclosures

This is a great opportunity to empower investors, but Morningstar recommends doing more.

The Securities and Exchange Commission is considering a major proposal that would dramatically change the disclosures that investors receive when investing in a mutual fund. The heart of the proposal is a new, concise annual report that is visually engaging and presents important information to investors in an easy-to-read format. The updated report will include information on the fund's performance, material changes, principal risks, and other appropriate information.

The proposal is a great opportunity to empower investors, but it could do more. 

Although the SEC's proposal generally improves transparency and accessibility for shareholders, Morningstar recommends several improvements that will enhance investment disclosures and further help people understand their investments.

Better Performance Data Will Allow for Comparability 
Investors need more details on performance reporting in annual reports to effectively compare investments. For example, the SEC proposes one- and 10-year performance information, while we recommend one-, three-, five-, and 10-year returns because many will be better served by an immediate or intermediate time horizon.

Returns also need to be properly benchmarked. The SEC's limitation of benchmarks to broad-based indexes is unsuitable for many investment strategies, such as funds focused on value stocks or multi-asset strategies. A balanced strategy investing in stocks and bonds is not treated properly if benchmarked to the S&P 500.

Investors Should Be Told That the Board Represents Them 
Annual reports should provide investors with greater disclosures regarding board incentives and obligations. The fundamental nature of an investment company is that independent directors represent the interests of shareholders, and we would like to see this clearly communicated in the annual report.

The annual report should explain to investors that they are owners in the fund, and the portfolio managers work for them by way of an independent board. We also think investors should be able to find contact information for the board without searching obscure documents.

The Commission Should Go Further to Improve the Quality and Availability of Structured Data 
The SEC first made data electronically accessible with EDGAR in 1984, and by 1996, EDGAR filing was required for all domestic issuers. As SEC Commissioner Allison Herren Lee noted in November 2020, the introduction of structured data requirements for financial statement and prospectus information has had significant benefits for investors, analysts, and other market participants. Structured data makes it easier and less costly to extract, filter, compare, and otherwise analyze disclosure information.

We recommend that every data point in the shareholder report be tagged as the information in these new, concise reports is the most important for investors to compare funds. 

It Is Time to Rationalize Expense Ratios 
There's an opportunity to fix a number of issues in how the SEC-required expense ratios are calculated, making them more accurate and comparable across funds. It's worth noting that Morningstar analysts already use a modified version because the SEC requirements can be quite misleading.

First, both the annual report expense ratio and the prospectus expense ratio should exclude interest expenses and dividends paid on short sales, as the Morningstar adjusted expense ratio methodology does. By removing these expenses, investors have a better idea of what they are being charged by a fund company for the cost of running the fund. This exclusion allows funds with different types of investments to present their expenses in a comparable way.

Second, the prospectus expense ratio should include acquired fund fees and expenses, or AFFEs, and other specifics for funds of funds, and the threshold for displaying AFFEs should stay where it currently is. Allowing funds to disclose those fees only when the investment constitutes 10% or more of a fund, as proposed, is too high. 

Morningstar estimates that 5% of all funds would no longer include AFFEs in their expense ratios with this proposed threshold. Changing the AFFE threshold to 10% would result in misleading information that understates the cost of an investment, particularly for funds of funds, such as target-date funds

We Recommend Improving Fee Disclosures 
The SEC's proposal presents an opportunity to enhance transparency in fee disclosures for investors. We believe the annual report should alert investors to whether any payments are made to intermediaries for research or distribution. This disclosure benefits shareholders by alerting them to the presence of fees that may create a conflict for the financial intermediary with which they work and soft-dollar fees that may indirectly reduce their returns.

Additionally, funds should be required to report detailed information about these fees. By providing more detailed information in the N-CSR form, the information would be accessible to investors, empowering them to question potential conflicts in the advicethey receive.

We urge the SEC to make the most of this massive effort with a final rule that's even more impactful than the proposal.