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When It Comes to Funds, Read the Fine Print

Morningstar’s analysis of global disclosure practices serves as a reminder that there’s no excuse not to become an informed investor.

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Toward the end of 2020, Morningstar released the latest iteration of its Global Investor Experience study, with the chapter focused on Disclosure. I contributed to the study as the primary researcher and author for the section on the U.S. market. This study plays a valuable role in pushing the global fund industry toward best practices.

In this column, I’m using my work on the “2020 Global Investor Experience Study: Disclosure” as a jumping-off point to consider a more basic question: What does disclosure mean in the context of mutual funds, and why should it matter to investors? The truth is that disclosure practices aren’t just an abstract concept of concern to regulators and asset managers--they’re highly relevant and of tangible value to investors.

What is Disclosure and Why Does it Matter? Think of disclosure, broadly, as the information that fund companies and their representatives provide investors about their products, either at point-of-sale or for ongoing communications. For the purposes of the GIE, we identified disclosure best practices in the following areas:

  • Prospectus language;
  • Fees;
  • Portfolio holdings;
  • Portfolio manager name and compensation;
  • Sales practices; and
  • ESG and stewardship.

We focus on the regulatory requirements in each market, though of course fund companies are able and encouraged to go beyond those levels. But the government requirements provide us with a baseline that we can compare across countries, along with insight into the mostly broadly applicable experience investors can expect in those markets.

Why should we, as investors, care about disclosure? For one thing, fair and efficient markets rely on transparent and widespread distribution of information. There are certainly valid arguments supporting the notion that fund managers shouldn’t become completely open books, but in general to the extent that one believes in efficient markets, the more transparent the data the better.

Another important implication for disclosure concerns incentives. How fund managers and intermediaries are compensated can potentially influence the way they run or sell fund products, so it’s critical that rules enable investors to fully understand the motivations that drive recommendations, and any conflicts of interest that may exist.

Finally--fees, fees, fees. Morningstar research has consistently shown that fund fees are one of the top predictors of future success. Thus, having consistent standards for fee disclosure, and in formats that are meaningful and easily interpretable by investors, is of utmost importance.

Thinking about all these points in the broadest sense, as the GIE report notes, “Transparency is important to investors as it helps them make better decisions and creates trust in the vehicles used for investment and the firms that manage client assets.”

How Does the U.S. Stack Up? Fortunately for U.S. investors, the U.S. has consistently ranked near the top for disclosure, and the 2020 GIE study is no different. Along with India, the U.S. earned a Top grade. I won't get into extensive detail here--if you're interested, you can check out this summary, where you can also connect to the full report--but I'll touch on a couple of highlights, as well as areas for improvement.

The U.S. is a leader in terms of manager disclosure: Firms must disclose who runs a fund and for how long, the structure of their compensation, and how much they’ve invested in their funds (within certain predefined brackets). We also fare well in our prospectus requirements, with mandated performance and risk discussions, plain language in simplified prospectuses, and illustrations of fee impacts. And most key documents are easily accessible through the SEC’s EDGAR website. However, in many cases those performance discussions are perfunctory, and we’d prefer to see more robust and detailed treatments. In addition to those fee disclosures, another plus is that fund companies are required to assess the reasonableness of fees through the 15(c) process, but those results are not made public, so we’re a half-step behind the U.K. with its Assessment of Value report.

Portfolio disclosure is more middling. Required quarterly disclosure is a positive, but monthly portfolios are a best practice. About 60% of U.S. fund managers provide monthly holdings voluntarily. Our 33-day average lag time for reporting portfolios is an above-average speed, but several countries manage to post an average time of two weeks or shorter.

The U.S. has bolstered its sales disclosure requirements in recent years, with the Regulation Best Interest and Form-CRS Relationship Summary rules finalized in 2019. Technically, however, funds can be sold prior to an investor’s receiving a prospectus, which is not a best practice.

One area where the U.S. lags significantly behind is disclosure for environmental, social, and governance (or ESG) issues. That’s not surprise, as the U.S. fund industry and investors have been slow to catch up to Europe, especially on ESG investing. (Because this is a new area for the GIE, it was weighted less in the scoring and thus did not harm the U.S.’s overall rank.) However, the trends are shifting, and it’s likely that this will become a greater area of focus in the coming years.

One final note is that the SEC issued a new disclosure proposal in August 2020 that stands to further streamline and improve disclosure practices in the U.S. Morningstar agrees with much that’s in the proposal, but also has suggestions for improvement.

Making Disclosure Work for You While the government can establish disclosure standards for the fund industry, it's up to us as investors to actually read those documents and make the most of them. One advantage of mandated disclosures is that third-party firms can collect and aggregate that data, turning it into the Morningstar reports and analytics that you know and love. But even if you rely on Morningstar's (or someone else's) data, there's a lot to be said for digging into the primary sources on your own. Outside of government or third-party websites, fund company websites are also usually an excellent place to find key documents for a fund assembled in one place. A couple of key areas to focus on include:

What is my manager's strategy? Surely you purchase a fund because you want exposure to a manager's strategy and not because of a recent hot run, right? While the "Investment Objective" section of the prospectus is still prone to generic statements like "capital income and growth," the "Principal Investment Strategies" usually provides a strong and detailed account of the fund's philosophy and approach. And don't neglect the "Principal Risks" section. Although the laundry list approach of the past has not been entirely dispensed with, material risks are usually cited with sufficient specificity.

Are there incentives or conflicts of interest? The fund prospectus, Form ADV, and Form CRS all require fund companies or the folks selling funds to provide information about potential conflicts of interest or payments received by financial intermediaries when selling products to you.

How much are you paying? The annual report discloses the fund's annual operating expenses (often referred to as the net expense ratio), and you can also see how much of that fee derives from management fees and 12b-1 distribution costs. Be aware, though, that acquired fund expenses, which are relevant in fund-of-fund products like target-date funds, aren't disclosed in the annual report; you can find those in the prospectus.

Who's running your money? Both the long and simplified prospectus will detail the managers running the fund, how long they've been there, and likely some biographical information. If you also pull up the Statement of Additional Information, you'll learn how much they have invested in the fund (within the SEC's predefined ranges) and the structure of their compensation package. While you're poking around the SAI, you can also learn about another important group of folks responsible for governance of your funds, the board of directors. This can provide details about their backgrounds, levels of investment, and how much they're paid.

What do you own? Mutual funds and exchange-traded funds are merely containers for underlying securities. While there's no way for an investor to stay on top of the hundreds or thousands of individual securities held in a portfolio of funds, it's not a bad idea to stay acquainted with at least the top holdings of your active managers, and to see how concentrated those holdings are. The annual and semiannual reports provide holdings info, and if you're really ambitious you can pull the more frequent N-Port filing off the EDGAR website. As a bonus, you can respond to that acquaintance bragging about their Tesla TSLA gains at a Zoom happy hour with, "Hey, I own that stock, too."

These questions are just starting points. Taking advantage of disclosure requirements is an important step toward making yourself a more informed investor.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Author

Josh Charlson

Director, Manager Selection
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Josh Charlson, CFA, is a director, manager selection, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. Charlson provides fiduciary services for retirement plans and is responsible for selecting portfolio managers and mutual funds.

Previously, Charlson was a director of manager research focused on alternatives research. He was an editor of the Alternative Investments Observer, a quarterly newsletter. Charlson was also a member of Morningstar's ratings committee for alternative strategies and the stewardship committee that oversees the manager research team's assessment of fund companies.

Before assuming the role overseeing the alternatives team in 2014, Charlson was a strategist for the manager research team, covering a number of risk parity, target-date, and other fund-of-funds strategies. He oversaw Morningstar's annual target-date series research white papers as well as its quarterly target-date series reports and ratings.

Prior to Charlson's role as a strategist, he served as a hedge fund analyst for Morningstar for two years and as a senior editor for Morningstar Associates for seven years, where he focused on retirement planning and advice solutions. Charlson began his career at Morningstar as a mutual fund analyst.

Charlson holds a bachelor's degree in English from the University of Michigan, as well as a master's degree and doctorate in English from Northwestern University. He also holds the Chartered Financial Analyst® designation.

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