In May1996, Arthur Levitt, the Chairman of the Commission, stated that
"... at least for the time being, we do not need to mandate a specific
risk measure..." but that funds would be asked to select names more closely
related to their investment practice and that a bar graph showing historic
annual returns should be included in a fund's prospectus, along with "...a
brief, plain English risk summary."
1. Current disclosure practices in the mutual fund industry are inadequate. Investors and their advisors need more information to help them assess the risks associated with investment in mutual funds.2. Since the impact of a single mutual fund on an investor's overall financial situation may be complex, a one-dimensional measure is often inadequate. For this reason, fund risk disclosure should go beyond the reporting of historic return variability. Investors and their advisors need information that can enable them to assess sources of future risk; in many cases, history may not be the best guide to the future.
3. To better communicate the sources of risk associated with mutual fund investments, fund managers should provide estimates of the principal risk factors that are likely to influence fund returns in the future. Specifically, fund managers should describe and quantify the expected relationship between their fund's future returns and relevant security market indexes as well as the likely extent of divergence of their returns from such indexes and the probable sources of such divergence. In subsequent periods, actual fund returns should be compared with the portfolio of market indexes previously selected by a fund. It is important that fund managers both provide estimates of exposures to key risk factors in advance and subsequently report returns relative to those same exposures.
4. Management predictions of future actions and outcomes are, of necessity, subject to error. Thus the SEC must provide an adequate safe harbor for such predictions so that managers can provide honest estimates without fear of later litigation.
5. We hope that individual investors and sponsors of retirement plans that use mutual funds will demand that fund managers provide the above information, thereby avoiding the constraints and costs of mandated disclosure.
By its very nature, risk concerns the uncertain future. While investors know (or can know) what happened to a fund's returns in the past, their primary need is to predict the likely range of a fund's returns in the future. The greater is this range, the more risky are a fund's prospects.
Investments in funds are risky because they are exposed to economic forces or factors for which the future is uncertain. Some of these are unique to individual funds, but many are common to many funds. Thus, a U.S. stock fund will typically move to a greater or lesser extent with the overall U.S. stock market. A fund's risk depends on how closely its return is coupled with given indexes, the riskiness of each index, and how closely the indexes tend to move together.
A fund manager can communicate the nature of exposures to major risk factors of this sort by specifying a portfolio of security market indexes that, averaged over the next two to four years. is likely to have exposures similar to those of the fund. Thus, a growth stock fund might specify that a U.S. growth stock index would be an appropriate benchmark for this purpose. Another fund might select a combination of indexes, with 5% in a money market index, 75% in a value stock index, and 20% in a non-U.S. stock index. The Roundtable recommends that each fund manager provide a well-defined index or portfolio of indexes so that investors can be informed of the fund's likely future exposures to major sectors of the security markets.
Since disclosures of this nature will, of necessity, describe management's intentions and predictions concerning future actions and outcomes, the SEC should provide an adequate safe harbor by specific reference under Rule 175 so that funds can provide honest best estimates without fear of later shareholder litigation.
Investors must ultimately be responsible for understanding or making predictions about the risks associated with major market sectors, as well as the extent to which sectors are likely to move with one another. Much of this information is common to many funds and thus can be most efficiently provided to investors by third parties such as financial planners and database providers. In contrast, the manager of a mutual fund is in the best possible position to predict his or her intended future investment strategy and to choose a benchmark portfolio of indexes that best describes that strategy.
In some respects this proposal resembles the SEC requirement that each fund compare its historic returns with those of a broad-based index, preferably one provided by a third-party. However, there are three major differences. First, in many cases, funds can provide better information if they use narrow-based indices. Second, where relevant, funds should use portfolios of indexes. Third, and most importantly, a fund should select a benchmark of indexes representative of future investment strategy whether or not this benchmark was representative of the fund's past strategy.
Many narrow-based indices could be used for this purpose. Some examples are:
While it would be useful to formally quantify the non-factor risk arising
from one or both of these activities, this may be difficult to do with
precision. However, fund managers should provide a narrative account of
the likely divergence of their fund's returns from those of the selected
portfolio of indexes and the extent to which such divergence is likely
to be due to (1) concentrated holdings and (2) rotation among asset classes.
Despite these caveats, the historic variability of returns still provides
useful information for many investors. Thus, the Roundtable does not oppose
the presentation of information on historic returns for the benchmark portfolio
of indexes selected by a fund for the forthcoming period. However, it advocates
that any chart based on the previous returns on such a portfolio show the
difference in the portfolio's return each year from the average portfolio
return over the years portrayed in the chart. Such a presentation emphasizes
the effects of risk rather than on historic average returns. Both theory
and empirical evidence indicate that history is a much better predictor
of future risk than of future average return.
revised on March 26, 1999 by jsloan@luc.edu
http://www.luc.edu/orgs/finroundtable/statement96.html