The commissioners and staff at the Securities and Exchange Commission have been working around the clock, looking for ways to refine and improve regulations in the aftermath of one of the worst recessions in history, but this important work takes a delicate touch. Changes to one area could have unexpected ramifications to other areas, and every move must be planned with care and consideration.
The SEC's Andrew J. "Buddy" Donohue, director of the division of investment management, is known for his cautious, measured approach. Donohue recently spoke with Money Management Executive and revealed his insight into the Commission's progress to reform summary prospectus profiles, target-date funds, money market funds, custody rules for investment advisors and the use of complex, risky instruments.
MME: How popular and helpful do you expect summary prospectuses to be among investors?
Donohue: I expect them to be extraordinarily helpful. There was an incredible amount of preparatory work that went into developing the summary prospectus. We worked very closely with investors, the investment companies and broker/dealers to understand what it is investors would like to see. There was incredible similarity in the types of information that brokers found useful in terms of talking to their clients and the info that had been developed for the profile.
We also looked at information that retirement plan and 401(k) investors were using and found that the information was very similar, if not identical to, the information we were suggesting.
I think we've identified the important information that folks need to make an initial decision. We have created a mechanism for individuals and their advisors to easily navigate from the simple information to the more detailed information that's provided in the full prospectus and the statement of additional information. The feedback that we're getting has been very positive.
MME: How is the SEC working to modernize fund and advisor regulations?
Donohue: In addition to the summary prospectus, we are looking at data tagging for risk/return information in the annual and semi-annual shareholder reports. We think that will be a helpful tool for investors for comparison purposes.
If you've ever picked one up, they are rather lengthy. They're patterned after corporate annual and semi-annual reports. We've been hearing for years that a lot of people just throw their annual and semi-annual reports in the garbage. The cost of printing them is borne by shareholders.
If we came up with a document that they would actually read, that would be helpful and would save investors money at the same time.
On the advisor side, last year we proposed Form ADV part II. It was intended to be a narrative that would be much more useful, easier to understand and more meaningful to investors. It would also be electronically available.
Let's say you were considering hiring an investment advisor registered with the SEC. If you went online, either on the SEC's website or the website for that advisor, you could not see their brochure. You could see their ADV part I, which has a lot of information relative to the advisor itself, but you wouldn't get the other really important information unless you called them up [to ask them] to manage your money.
As revised, ADV part II would do a couple things: One, it would make the filing of those brochures electronic, and secondly, it would make the forms themselves much more meaningful and understandable for investors.
MME: What are you doing about books and records?
Donohue: That is a huge task for us, part of our longer-term plans. Those rules were written in the '60s. When I was an economics major in college in the '60s and '70s, we didn't have access to a computer.
The world has changed dramatically since then, and the way that firms create, maintain and access their records is significantly different. Back then, anything electronic was the exception. Now, anything paper is the exception. It's an important initiative for us, but it's more important to do it right, and we are acting in a quite deliberate manner.
To give you a sense of the universe, we have over 11,000 investment advisors managing $33 trillion of investor money registered with us. They run the gamut from the huge firms that we all know about to the very small. The latest figure I saw said that about 69% of advisors registered with the SEC have 10 or fewer employees. There are a number of what we call dual-registrants, firms that are both advisors and broker/dealers at the same firm.
As we think about the advisor space, we always have to be mindful of how the large and small advisors currently keep their records and how we could harmonize the rules with those of broker/dealers.
MME: How practical or likely is it that the SEC will regulate holdings, marketing and disclosure of target-date funds?
Donohue: It isn't well known, but target-date funds inside retirement plans are not all investment companies registered with the SEC. Many are collective investment trusts that are provided by banks and trust companies.
Nonetheless, many of the target-date funds inside retirement plans and 401(k)s in particular have become default options. Previously, many plans had put them in stable value or money market funds.
The Commission and staff are considering what we should do. Clearly, retirement plans are a primary responsibility of the Department of Labor. We held a joint hearing with the DOL to get an appreciation for what issues there were and what, if any, action might be appropriate for either the DOL or the SEC to take relative to target-date funds. After examining many of these funds, I am comfortable that, in general, target-date funds had done what they said they would do and that the disclosure has been pretty clear.
Having said that, the question that has really surfaced with respect to target-date funds is whether or not the use of the name, like Target-Date 2015 fund, can mislead investors to have a certain expectation about what that particular portfolio will look like for 2015 and what it's trying to achieve.
One of the things that came out of the joint hearing with the DOL is that actually there are two different models for what target-date funds do. One is that the money is available on the target date for an investor to roll over into an annuity or some other choice.
The more prevalent target-date funds hold the expectation that the fund is managing your money up to your retirement and then beyond. So basically the glidepath will continue after 2015. The question is, how do you pick what asset classes and what asset mix you will want from 2015 throughout the rest of your retirement?
They're two totally different models. It's something we're giving a lot of thought to, because we don't want investors confused. Nobody should be making a decision solely on the name of the fund. We have rules that you can't have misleading fund names.
However, we don't tend to try and limit strategies people can use inside funds or to mandate asset allocations or things of that nature. That's not what the Commission has historically done, as long as they're compliant with the provisions of the Investment Company Act of 1940 and their disclosures to investors.
MME: What is the stance of the Division on changes to money market mutual funds?
Donohue: We've been through a challenging time for money market mutual funds. They have almost $4 trillion of investors' money in them, and they have weathered the financial crisis relatively well.
Certainly, while there were funds that had issues with liquidity and some credit events, with one fund breaking a dollar, if you look back over a 25-year span, there have only been two retail funds that broke a dollar. That tells you the model is pretty good.
Still, there are some things we could do to help improve money funds. Thus, in June, the Commission proposed some changes to Rule 2a-7 that we felt would improve the money market fund model. The proposal would require the funds to maintain a portion of highly liquid investments, reduce long-term debt exposure and limit their investments to only the highest quality portfolio securities. Monthly reporting requirements were also proposed, as well as allowing a money market fund to suspend redemptions if it "breaks a buck" in order for fund assets to be liquefied in an orderly fashion.
Some of these changes were ones that were similar to or the same as had been suggested by a working group put together by the Investment Company Institute. Others were changes we felt were important. We had a ringside seat for the last two years when money funds were going through many of their issues. I think that gave us a very useful perspective on what many were facing. We're hopeful we can get some pretty good feedback on the proposal.
MME: The mutual fund industry is very concerned about the possibility of a floating net asset value for money market funds. If the stable NAV of these funds is lost, won't investors lose interest in these products-and the mutual fund industry be in danger of losing 40% of its assets?
Donohue: I've spoken on occasion about some of the benefits that come from floating NAVs, as well as some of the disadvantages that can derive from a constant dollar and its lack of sensitivity to changes.
The very thing that makes a dollar net asset value ("NAV") attractive to investors is that it remains stable. Yet there is an opportunity for people to buy portfolios at a slightly lower NAV. Had they used $10, you'd have a higher degree of sensitivity. Something that would be a $0.997 and rounded to $1.00 in a typical money market fund would actually be $9.97. The opportunities for some people to take advantage of these funds was much less of a concern when 2a-7 was amended last time, because it was very much a retail market back then.
Now it's very much an institutional market, and institutions can move a lot of money quickly. I'm concerned about what we can do to ensure that a money market fund and its remaining shareholders can't be taken advantage of.
The floating NAV is something that addresses some of the concerns I've raised. To the extent that people have gone out and showed the benefits to investors of the dollar, that's been helpful, but we're also hopeful that people can come up with an approach to deal with the negative issues that come from the use of the dollar. I think the industry's been less successful in terms of addressing some of those issues.
We understand the concern the industry has, but we're still exploring the floating NAV. I'm not sure that either they or we have a good sense on what the behavior will be under all circumstances. This is an investment product that has been beneficial to investors as well as being an enormously important funding vehicle for American corporations. We're taking a very deliberative approach.
MME: What about simply separating retail funds from institutional funds?
Donohue: I think that's possible, although the industry indicated that they've had some difficulty with it. But if you have a $1 million minimum investment, I would not characterize that as retail. If you had a $5,000 minimum investment, that's probably not going to be too attractive to institutions.
However, there is a crossover that is of concern to people. For example, a big brokerage firm may have the sweeps from its clients' brokerage accounts placed in an institutional fund. In other words, they've cut a good deal for their clients, and there will be only one account that will show up, but it will represent the sweeping for all of the brokerage firm's clients' money into that fund.
We saw significant differences in behavior by funds based on whether they were institutional or retail during the market break. We think it would be helpful to distinguish them. We proposed in our money market fund reform that we treat institutional money market funds differently for the purposes of the amount of liquidity that they would have to maintain.
If we couldn't differentiate between the two, then retail funds would need to maintain the more stringent requirements of the institutional funds. By coming up with the means to distinguish between the two, you might be able to enable the retail fund and its investors to be able to get the benefit of not having to maintain liquidity that they're not going to need.
We also recognize that there may be difficulties in making the call if it's a close call. In that regard, our proposal was to leave that determination up to the fund boards. We tried to build in flexibility and in certain areas to not have a one-size-fits-all answer. The responses we've heard orally from people have been, "It's really hard to do," and, "We can't do it." If that winds up to be the case, then I guess everybody ends up being treated like institutions.
MME: How is the division working to offer guidance to fund advisors on what you have cited as some of the biggest challenges facing the industry in the wake of the financial crisis-notably derivatives, leverage, counterparty exposure, credit ratings agencies, securities valuation and risk management?
Donohue: If you look back at some of the dialogues we have had with the industry over the past three years, they were about derivatives, counter-party exposures and risks inside funds. We've been working with the industry on these critical issues, and the industry's been responsive.
On the issue of being able to deal with leverage, one of the items we put up on the SEC's website is a list of SEC documents to assist with so-called senior security or Section 18 issues, which get paid before common stock. All debt gets picked up there and all preferred stock gets picked up there. We have put up on our website all of the releases and interpretive guidance that have been given out in this area so that practitioners in the industry can go and find them all in one place.
We've been fortunate to have Susan Ervin join the division. Susan is one of the foremost experts on derivatives, having most recently been a partner at Dechert.
On valuation, we've done a lot of work on pricing and guidance. If you go to our website, there is a bibliography of SEC documents with click-throughs. There are 13 pages of guidance relative to valuation. I understand that earlier last month, the ICI put a similar document up on their website.
MME: How can the custody rule be improved to prevent future frauds? Will having an auditor guarantee investors their money is safe, or is further due diligence needed?
Donohue: We've made some suggestions to improving the custody rule for investment advisors, but the proposal is still out for comment.
In the case of almost all the big institutional clients, custody is selected by the client, not by the advisor, and is typically seated with a bank, where they have a bank supervisory mechanism in place, or at a broker/dealer.
Generally, the custody arrangements are appropriate, but the Commission's proposal seeks to improve it.
Regardless, in many cases like custody, it's always good for clients to be diligent and ask questions.
MME: Of all the regulatory changes and efforts on your agenda, what would you say is the Division's main focus for the remainder of 2009?
Donohue: The custody rule, target-date funds and adopting ADV part II. While it may be a stretch, we'd love to be in a position to make a recommendation on shareholder reports, money market funds, hedge fund advisors and regulatory reform before the end of the year and 12b-1 fees early in 2010.
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