Fund Rules the Way We'd Write Them

On Feb. 25, 2004, in testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, Don Phillips offered Morningstar's perspective on the ever-widening mutual fund scandal. He also endorsed a number of remedial steps that would serve to protect the investing public and restore the trust breached by the spate of abuses uncovered thus far.

The reforms that Don outlined--such as eliminating soft dollars, strengthening fund director accountability, and disclosing manager compensation--should sound familiar to Morningstar readers. We have long been critical of shareholder-unfriendly practices like excessive fees. Likewise, we have also been vocal supporters of measures that would enhance the transparency of information that shareholders use to make their investment decisions.

In that same spirit, Morningstar recently took steps to play an even more vigorous role in the process for reforming the industry--specifically, the SEC rule-making process. The SEC has floated a number of proposals in recent months aimed at stemming the tide of unethical practices that have surfaced. In various other proposals, the SEC is re-examining a slew of contentious, but vitally important, issues, such as rule 12b-1, disclosure of expenses, and fund board governance. Taken together, the SEC’s rule-making docket holds the potential to push the industry back towards equilibrium, where investors can once again rest assured that fund firms are acting with their best interests at heart.

Doing Our Part
But how can Morningstar affect change via SEC rule-making? In the same way any citizen can--by submitting comments on SEC proposals. The SEC solicits feedback on its proposals from all interested parties, giving novices and professionals alike a great opportunity to participate in the process of regulation. Morningstar is seizing that opportunity by expressing its views on each of the SEC proposals that bear on the mutual fund investment process. To that end, we recently submitted comments on the SEC proposal titled "Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings." Following is a brief description of the proposed rule's main provisions and a synopsis of the general and more specific views we expressed.

Going forward, we will keep readers apprised of our views as we comment on other rule proposals.

The SEC Proposal and Our Views 
The proposal in question seeks to improve the scope and transparency ofdisclosure concerning safeguards against frequent trading, fair-value pricing policy, and selective disclosure of portfolio holdings. In particular, it would require funds to provide the following general categories of disclosure:

• The risks that frequent purchases and redemptions of fund shares might present to investors.
• Fund board's policies and procedures concerning frequent purchases and redemptions.
• Circumstances under which fair-value pricing will be used.
• Policies and procedures governing disclosure of portfolio securities to selected parties.

Overall, Morningstar supportedthe proposal, which should improve the scope and quality of mutual fund disclosure, thereby further leveling the playing field for mutual fund investors. Detailed below are additional suggestions that we urged the SEC to consider when instituting different types of disclosure rules.

Frequent Purchases and Redemptions: With respect to disclosures concerning frequent purchases and redemptions of fund shares, we encouraged the SEC to consider the following to improve the breadth and clarity of the information:

• Require disclosure of definition of "frequent purchases and redemptions." This enhancement would serve to highlight variations in how different fund boards define market-timing and, if not enforce uniformity, provide a basis for comparison.
• Require disclosure of whether the definition of “frequent purchases and redemptions” and procedures governing frequent purchases and redemptions also extends to advisor personnel.
• In cases where a board has not adopted market-timing policies and procedures, require disclosure of whether such activity is encouraged, expected, or tolerated, along with an estimate of the costs long-term shareholders are expected to incur as a result.
• With respect to arrangements to permit frequent purchases and redemptions of fund shares, broaden disclosure to include “circumstances”, in addition to “persons.” In cases where a firm has made arrangements with a defined contribution plan, the list of persons who have conducted frequent trades could be very lengthy. This simplification should make the rules less onerous.

Fair-Value Pricing: We also offered a number of suggestions concerning the proposal to disclose the circumstances under which fair-value pricing will be used.

1. Strike a balance between assuring that a well reasoned fair-value pricing mechanism is in place and mitigating the risk of enhancing market-timers' ability to "game" the system by describing the following:

• The qualitative factors that trigger a fair-value pricing adjustment, the parties responsible for making fair-value pricing adjustments, and the process for arriving at a decision regarding the necessity and magnitude of an adjustment.
• Whether or not specific, quantitative factors trigger a fair-value pricing adjustment. If not disclosed, the prospectus should describe in meaningful detail why the fair-value pricing committee believes such disclosure would ultimately be harmful to shareholders.
• The manner in which an adjustment is made (e.g., at the level of the individual security, the regional level, etc.).
• The number of days during the most recent fiscal year that the fair-value pricing policy triggered an adjustment (with a breakdown of upward and downward adjustments).
• The number of days during the most recent fiscal year that the fair-value pricing adjustment changed the fund's net asset value by 5% or more (with a breakdown of upward and downward adjustments).

2. Clarify the pricing model that a fund should use when multiple estimates of fair value are available.

3. Clarify the circumstances under which fair-value pricing would be required. Based on the proposal, fair-value pricing would be applied to any security for which a fair value is not readily obtainable. This would potentially include high-yield bonds, municipal bonds, and small-cap stocks, to name a few.

4. Require all funds that invest primarily in foreign stocks to institute redemption fees. We believe that redemption fees, when used in tandem with fair-value pricing, should significantly reduce, if not eliminate, stale-price arbitrage opportunities.

• Lift the current 2% cap on redemption fees. This will afford funds the flexibility to levy higher redemption fees and perhaps encourage some funds to embrace "tiered" redemption fee structures that step down depending on the length of the holding period.
• Also, give funds the ability to grant hardship exemptions to investors forced to redeem under extenuating circumstances, such as a job loss, provided such circumstances are plainly disclosed.

Selective Portfolio Disclosure: With respect to proposed selective disclosure of portfolio securities, we urged the SEC to consider the following:

• The proposal would require funds to disclose instances of selective disclosure that are subject to confidentiality/nontrading agreements. Instead, mandate that any disclosure that departs from the fund's standard disclosure policy be subject to a confidentiality agreement and prohibit any arrangements that would allow a party, other than those managing the portfolio (as is common in subadvisory arrangements), to trade on such information.
• Do not exclude any arrangements subject to a confidentiality/nontrading agreement from the proposed disclosure requirements.
• The proposal would require funds to disclose receipt of compensation or other consideration by the fund, its investment adviser, or any other party in connection with the disclosure of information about portfolio securities. Instead, ban such practices outright as they clearly represent a conflict of interest that puts fund shareholders' interests at risk.
• Do not set forth the identity of each party for whom an exception to the standard portfolio disclosure policy is made. Rather, describe the circumstances.