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Fund of Funds Proposal: The SEC’s Plans to Streamline Fund Approval

What we told regulators about the SEC’s proposed rules

Jasmin Sethi

 

The SEC has released a proposal that would streamline approval of funds of funds. This proposal would have a significant impact on individual investors who are saving for retirement, as many target-date funds are funds of funds and their assets have played a larger role in the defined-contribution system over the past few years.  

In fact, Morningstar’s Target-Date Fund Landscape report shows that in 2018, target-date mutual fund assets surpassed $1 trillion and garnered an all-time high of $55 billion in estimated net flows. This is on par with target-date mutual funds’ past performance, which has included more than $40 billion in net flows each year since 2008. This growth indicates the potential extent of the impact of the SEC’s proposed rules.  

Here, we share our perspective on the opportunities and risks of the proposal. 

How the SEC’s funds of funds proposal could benefit investors 

We support streamlining the process for approval of funds of funds. The SEC proposes creating one regime to govern fund of funds, regardless of the fund type (open-end mutual funds, exchange-traded funds, business-development companies, closed-end funds). This would standardize the regulatory landscape for these funds instead of having a slew of no-action letters, exemptive relief, and other guidance governing individual fund complexes. 

We believe this SEC-proposed rule is a wonderful opportunity for the Commission to introduce more simplicity and standardization to the fund world in the way that last year’s ETF rule did.  

The SEC should tackle the risks of anti-layering through disclosure 

This SEC-proposed rule would prohibit most three-tier funds, with limited exceptions, due to concerns about the structure’s ability to conceal details about investments, fees, and risks.  

In our letter to the SEC, we express the belief that the Commission’s concerns about lack of transparency should be addressed through disclosure, not by restricting products. For instance, expense ratios in annual reports currently differ from those in prospectuses. The SEC requires funds of funds to disclose the expenses of funds in which it invests in their prospectus fee tables, but they are not necessarily disclosed in the annual reports. We believe the expense ratios should be accurately disclosed in both the investment company’s annual report and the prospectus. 

We encourage the Commission to take this opportunity to make disclosures consistent and accurate in this area.  

The 3% threshold will present liquidity challenges  

The SEC has also proposed prohibiting funds that own more than 3% of an acquired fund from redeeming more than 3% of that fund’s outstanding shares during any 30-day period.  

Morningstar finds that this change could negatively impact fund liquidity and inhibit current portfolio-management techniques, as an estimated 1,591 parent funds with market size greater than $1 billion own more than 3% of one or more acquired funds. Moreover, these funds include many that earn high Morningstar Analyst Ratings—241 have a Gold, Silver, or Bronze rating—meaning that high-quality funds will face challenges under the proposed rule.  

These redemption conditions could be particularly challenging for target-date funds, which make up more than 20% of funds of funds, because they purchase and redeem in a manner consistent with their glide path strategy. The conditions would likely incentivize target-date funds to acquire smaller shares of multiple acquired funds, rather than larger shares of fewer funds. Because target-date funds are popular among individual investors saving for retirement in 401(k) and IRA plans, investors could be subject to higher costs or less-effective strategies.  

The SEC has not clarified how this requirement would interact with the liquidity rule, which imposes stringent requirements for mutual funds to manage redemptions in the context of their liquidity risk-management program. We encourage the Commissioners to eliminate this redemption threshold as they move toward a final rule.  

Ultimately, we hope that the Commission will carefully consider how to proceed with a final rule that simplifies the landscape for funds of funds without creating regulatory challenges that grant few benefits to individual investors.  

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