Dear SEC

KISS
Dear SEC:
I read your proposal Investment Company Advertising: Target Date Retirement Fund Names and Marketing. Once again, thank you for the process. Although government regulators are not customarily thought to be good listeners, the SEC certainly has proved it is with its mutual fund amendments. Its solicitations for comments are genuine. Frequently, as with this proposal, the SEC has modified its initial release to incorporate outside viewpoints. (This author was not nearly so considerate when he oversaw Morningstar's fund calculations.)

This particular item is the mutual fund regulator's equivalent of the Maginot Line. You surely realize this. As the default option for 401(k) plans, target-date funds are justifiably the most politicized of all fund categories. Their poor 2008 performances, particularly among the short-dated 2010 funds, which had been regarded as very conservative options, put them in Capitol Hill's firing line. In September 2009, target-date funds were the subject of a Senate hearing. In that atmosphere, the SEC had no choice. You had to take action. You had to show that you could win the last war.

Which you did. Even without this proposal, you will win the next war, too. Target-date funds have among the lowest redemption rates of any mutual funds. Thus, enhancing disclosure so that target-date investors better understand their portfolios, thereby avoiding panic and untimely redemptions, is addressing a problem that largely does not exist.

As you surely also realize, the furor over target-date funds' 2008 performances was largely created by target-date providers. Those with lower equity allocations, who had trailed the performance derby through the mid-2000s, were delighted by the reversal in relative fortune. Now they led the performance charts. Some providers were happy to take things a step further by tut-tutting at the irresponsibility of their more stock-heavy competitors, implying that they had bilked their investors and sent them into retirement ruin. A few crocodile tears, and the politicians were properly fertilized.

At least real damage was not inflicted on the Hill. While the Senate initially toyed with establishing investment limits on equity holdings for target-date funds, it quickly came to its senses and recognized that, to the extent that a problem did exist, the issue would be best served by information, not restrictions. It's true that because there is a limit on the number of times that the SEC can require additional disclosure, this proposal comes with an opportunity cost. But an opportunity cost is fairly mild as Washington problems go.

As for the proposal itself, I favor the original version: displaying the fund's equity glide path. I would keep the presentation as simple as possible. Classify all fund assets as either stocks or not. Then show the fund's anticipated stock percentage on a time line. Context such as the stock percentage of the average target-date fund, or the average balanced fund, might help. However, be very stingy when considering such data additions. It's very easy to overwhelm the user--who, after all, is unlikely to be an experienced investor.

Yes, there are problems with such a basic approach, as many of the proposal's comments have noted. There's a world of difference between a 60% stock portfolio that consists of blue-chip equities and short, high-quality bonds and a 60% stock portfolio that uses small-company and emerging-markets stocks, junk bonds, and commodities to fill its nonequities allocation. Those two funds would look identical in my presentation, and they most certainly are not.

But if there is one thing that I have learned about investment information in 25 years, it is that the great is very much the enemy of the good. Yes, not every 60% equity allocation carries equal risk, nor does every 40% bond allocation. But broadly speaking, those are useful numbers. In the next stock-market crash, a target-date fund with a 60% stock weighting is very likely to trail one with a 30% stake. (Most likely, its losses will be roughly double.) Summary charts need not be perfect to be useful.

Certainly, the equity glide path beats the revised recommendation offered by your Investor Advisory Committee. Perhaps guided by the comments that criticized the equity glide path as being overly simplistic, your committee suggests using a risk-based glide path rather than an equity-based glide path. That is, instead of showing a fund's stock percentage over time, the target-date fund's glide path would show its projected standard deviation (or possibly another risk statistic).

I do not see how that can work. Pretty much everybody, including the defaulted target-date investor, understands that stocks are the riskiest portion of a portfolio, and that holding more stocks makes for more risk. That a fund has one third as many stocks, in percentage terms, as the Dow Jones Industrial Average gives a rough indication of the fund's volatility. A standard deviation number, in contrast, has no intuitive interpretation. It will be utterly meaningless to most users without substantial context--so much context that reading the chart will become a statistical exercise. That is a chart destined to be ignored.

There is also the issue of comparability. Determining planned future equity allocations is easy; define "equity," have fund companies tote up what percentage of a target-date fund's expected holdings will fit the definition over time, and voila!, a standardized equity-glide path. The figures will be directly comparable. The same will not hold true if fund companies calculate their own versions of expected portfolio standard deviations, as there is no standardized approach (so to speak). In such a case, the Commission would need to specify the calculation's details--a daunting task that you may not wish to undertake.

Finally, at the risk of being impolite, these figures are fake. They are estimates, based on past observations and perhaps leavened with views about how the future might be different. If a target-date fund prints that it has an expected standard deviation of 12% annually in 2020, that doesn't mean that it will actually have a 12% standard deviation when that year arrives, even if it sticks completely to its current investment plans. Perhaps the financial markets will become dramatically more or less volatile. In contrast, a projected equity allocation is real; unless the fund alters its approach, the equity-glide path will prove accurate.

These problems with standard deviation are not alleviated by switching to betas, semi-variance, or any other volatility measures. They cannot be avoided.

In summary, this proposal, first floated in 2010, has become much larger that it needs to be. It suffers from scope creep; it is now fulfilling the prophecy of the Investment Company Institute (the fund-industry trade organization) that this project would "become an enormous undertaking with questionable benefit."

Make it a small undertaking with a modest but positive benefit. Implement the equity glide path and move forward.

Thank you again for your consideration.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.