Most of us want to know how our money is being invested, how much we’re paying and what we’re getting in return for our capital?   Until recently, getting our hands on this type of information was a bit of a challenge.  Despite the mounting pressure on investment companies to provide investors with greater mutual fund transparency, the industry has continued to drag its heels to deliver it.  Last month the SEC took big leaps toward achieving this goal by requiring fund names to more accurately reflect portfolio holdings, and mandating disclosure of after tax return information.  

However, it still falls short of the level of disclosure that we ought to demand. But, give them credit, they are moving in the right direction.

What does the name of a fund really imply?

What’s in a name and what does that name infer? Well if the SEC can help it, lots.  The name of an investment fund has serious implications for many investors.  One of the new rules adopted last month prohibits the use of mutual fund names that may mislead investors about a fund’s investments and risks.

The new rule requires a mutual fund to invest at least 80% of its assets according to the particular investment type that its name suggests. This would include investments in:

• A particular type of investment (XYX stock, bond, or govt fund)
• A particular industry (ie. XYX health care fund)
• A particular county or geographic region (XYZ Argentina fund, XYZ Pacific Rim fund)

This allows investment companies to have the other 20% invested in other assets, like cash and cash equivalents set aside for shareholder redemptions.  Under the previous rule, only a 65% investment was required.

How does this help us?  Well, for starters, it provides a greater assurance that the fund’s investments will be consistent with its name.  Imagine owning what you think is an “equity fund” that had a fixed income position of 35%.  How do you think that would affect your investment objectives?  Critical to the success of an investment plan is the fund’s ability to stick to its intended objectives.  More disclosure reduces the chance that a mutual fund manager will stray away from the fund’s stated objective and this helps maintain more accuracy when defining one’s asset allocation goals.  Assets that are invested according to investor’s expectations enhance a portfolio design and efficiency.

Investment companies may, however, escape the 80% requirement rule but only after gaining prior shareholder approval.  Otherwise, a 60-day advance notice to shareholders must be given before the company can change the 80% investment policy suggested by its name.

The rule applies to investment types not investment strategies.   It does not extend to codify positions for fund names that include terms “balanced, index, small, mid, large cap, international or global”.  Neither does it apply to fund names that use terms like growth & value.  So, unless you buy an index fund, style drift is still inevitable.

Disclosure of after tax returns

Designed to help investors understand the impact of tax costs and better compare the after tax returns of different funds, the SEC adopted an additional rule requiring mutual funds to disclose after-tax returns for 1, 5, and 10 year periods in its prospectus.

The biggest drag on performance is taxes.  Every dollar you send to the IRS is a dollar less that compounds in your portfolio. Estimates indicate that between 2-3% of the average stock fund’s total return is lost to taxes any given year, much more than the average expense ratio.    The size of the tax impact varies by fund and depends on many factors including: portfolio turnover, amount of gains on trades, ability of manager to harvest tax losses.  For investors with taxable accounts, this may translate into a lot of money.

The proposed after-tax returns will be presented in two ways.  The first will show gains and losses for investors in the 39.6 tax bracket who held on to their shares and the other will show what the figures would be had they sold their shares.

The “after tax return on distributions” includes the effect of taxable distributions by a fund to its shareholders but not gain/loss realized by a shareholder on the sale of fund shares.  It reflects the tax effects on shareholders of a portfolio manager’s purchases and sales of securities.  While, the “return after taxes on distributions and sale of fund shares” reflects both managers’ purchases and sales of securities as well as shareholder’s decision to sell fund shares.

Before and after tax returns will be presented in a table, allowing investors to compare the performance of different funds.  Although the after-tax figures will not be applicable for investors with qualified plans, the new rule will give investors with taxable accounts a worst-case scenario to consider before actually buying a fund.

Alternatives

Fund managers argue that total disclosure forces them to share trading strategies with the competition.  Or, traders may find out about a manager’s intent to buy a stock and then drive up the bid price for that issue.

Let’s face it, complete mutual fund disclosure will never be realized in our lifetime.  But, the growing competition in the industry is certainly opening the doors to more choices and greater disclosure.  The actively managed “Naked funds” and “OpenFund” leverage the Internet to post daily portfolio changes and statistics as changes occur within the fund.  While tax sensitive investors should consider low-cost, tax-managed funds to keep gains low as well as index or exchange traded funds that have low turnover.  Whether or not mutual fund companies step up to the plate and bat, index-based products have always provided investors with greater transparency.