[Federal Register: December 24, 2003 (Volume 68, Number 247)]
[Proposed Rules]
[Page 74819-74828]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr24de03-37]
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Part VI
Securities and Exchange Commission
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17 CFR Part 270
Request for Comments on Measures To Improve Disclosure of Mutual Fund
Transaction Costs; Proposed Rule
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release Nos. 33-8349; 34-48952; IC-26313; File No. S7-29-03]
RIN 3235-AI94
Request for Comments on Measures To Improve Disclosure of Mutual
Fund Transaction Costs
AGENCY: Securities and Exchange Commission.
ACTION: Concept release; request for comments.
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SUMMARY: The Securities and Exchange Commission is seeking public
comment on a number of issues related to the disclosure of mutual fund
transaction costs. We seek comment on, among other things, whether
mutual funds should be required to quantify and disclose to investors
the amount of transaction costs they incur, include transaction costs
in their expense ratios and fee tables, or provide additional
quantitative or narrative disclosure about their transaction costs. We
also seek comment on whether mutual funds should be required to record
some or all of their transaction costs as an expense in their financial
statements. The Commission requests comment from investors, investment
companies, investment advisers, the financial services industry,
academics, regulators, and the public generally on the issues
summarized in this release, the specific questions located in Sections
III (Alternatives for Quantifying Transaction Costs), IV (Accounting
Issues), V (Alternatives that Provide Additional Information About the
Level of Transaction Costs), and VI (Review of Transaction Costs by
Fund Directors) of the release, and on any other issues that commenters
believe relevant.
DATES: Comments must be received by February 23, 2004.
ADDRESSES: To help us process and review your comments more
efficiently, comments should be sent by hard copy or electronic mail,
but not by both methods.
Comments sent by hard copy should be submitted in triplicate to
Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450
Fifth Street, NW., Washington, DC 20549-0609. Comments also may be
submitted electronically at the following E-mail address: rule-
comments@sec.gov. All comment letters should refer to File No. S7-29-
03; this file number should be included in the subject line if
electronic mail is used. All comments received will be posted on the
Commission's Internet Web site (http://www.sec.gov) and made available
for public inspection and copying in the Commission's Public Reference
Room, 450 Fifth Street, NW., Washington, DC 20549.\1\
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\1\ We do not edit personal identifying information, such as
names or electronic mail addresses, from electronic submissions. You
should submit only information that you wish to make available
publicly.
FOR FURTHER INFORMATION CONTACT: Paul Goldman, Assistant Director, or
Jacquelyn Rivas, Staff Accountant, Office of Financial Analysis,
Division of Investment Management, (202) 942-0510, at the Securities
and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-
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0506.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction
II. Background
A. Types of Transaction Costs
1. Commissions
2. Spread Costs
3. Market Impact Costs
4. Opportunity Costs
5. Magnitude of Transaction Costs
III. Proposals to Quantify Transaction Costs
A. Quantify Commission Costs Only
B. Quantify All Transaction Costs
C. Quantify the Effect of Daily Decisions to Trade
D. Sell-Side Alternatives
IV. Accounting Issues
V. Alternatives that Provide Additional Information about the Level
of Transaction Costs
A. Existing Disclosure Requirements
1. Portfolio Turnover
2. Dollar Amount of Commissions Paid
B. Improving Disclosure Related to the Level of Transaction
Costs
1. Disclose Transaction Costs in Terms of Rated Categories
2. Portfolio Turnover
3. Information about Average Net Flows
4. Other Narrative Disclosures
5. Brokerage Costs and Average Commission Rate per Share
6. Disclosure of Gross Returns
VI. Review of Transaction Costs by Fund Directors
I. Introduction
The Securities and Exchange Commission (``Commission'') is
considering various alternatives designed to improve the information
that mutual funds disclose about their portfolio transaction costs.
Mutual funds incur transaction costs when they buy or sell portfolio
securities. Transaction costs are significant for two reasons. First,
for many funds, the amount of transaction costs incurred during a
typical year is substantial. One study estimates that commissions and
spreads alone cost the average equity fund as much as 75 basis
points.\2\ Second, fund managers are subject to a number of conflicts.
Commissions, which are paid out of fund assets, may, for example, be
used to pay for research or trading support functions (brokerage
services) that might otherwise be paid for by the fund's investment
adviser (soft dollar commissions).\3\
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\2\ John M.R. Chalmers, Roger M. Edelen, Gregory B. Kadlec, Fund
Returns and Trading Expenses: Evidence on the Value of Active Fund
Management, Aug. 30, 2001, at 10 (available at http://finance.wharton.upenn.edu/edelen/PDFs/MF_tradexpenses.pdf
). These
estimates omit the effect of market impact and opportunity costs,
the magnitude of which may exceed commissions and spreads.
\3\ But see NASD Rule 2839 (K).
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Fund directors play a pivotal role in monitoring these conflicts.
As explained in further detail below, transaction costs are not readily
apparent to investors. These costs, however, must be disclosed to a
fund's board of directors where such costs bear on the reasonableness
of the fund's payments to the fund manager or its affiliates. Thus, it
is imperative that the fund's directors both understand and heavily
scrutinize the payment of such costs by the fund. The fund's board
should demand, and the fund's adviser should provide, all information
needed to undergo this review process. In the absence of vigilant
oversight by the fund's boards, transaction costs may include payment
for services that benefit the fund's adviser at the expense of the
fund.
Although transaction costs are taken into account in computing a
fund's total return, they are not included in a fund's expense ratio
because under generally accepted accounting principles they are either
included as part of the cost basis of securities purchased or
subtracted from the net proceeds of securities sold and ultimately are
reflected as changes in the realized and unrealized gain or loss on
portfolio securities in the fund's financial statements. As a result,
current disclosure requirements focus on providing fund investors with
information about two items that are related to transaction costs--
portfolio turnover rate and dollar amount of brokerage commissions. All
mutual funds (except money market funds) are required to disclose in
their prospectuses the annual rate of portfolio turnover that they have
incurred during the last five fiscal years. Investors can compare
turnover rates to obtain an indication of how transaction costs are
likely to vary among different funds. Funds (with the exception of
money market funds) also must disclose in the Statement of Additional
Information (``SAI'') the actual dollar amount of
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brokerage commissions that they have paid during their three most
recent fiscal years.\4\ The Commission is concerned that the current
disclosure requirements do not directly address a fund's overall
transaction costs or elicit sufficient information about these costs.
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\4\ All funds are required to provide their SAI to investors
upon request. In addition, the SAI of any fund may also be accessed
via the Commission's Web site (http://www.sec.gov) and frequently on
a fund's or a fund sponsor's Web site.
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Some investors and financial industry observers have expressed
similar concerns. For example, at hearings held on March 12 and
November 4, 2003 by the U.S. House of Representatives Subcommittee on
Capital Markets, Insurance and Government Sponsored Enterprises, and on
November 3, 2003 by the Senate Subcommittee on Financial Management,
the Budget and International Security, a number of witnesses testified
that inadequate information about portfolio transaction costs makes it
difficult for mutual fund shareholders to know the overall cost of
their investment.\5\
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\5\ The House of Representatives recently passed legislation
entitled the ``Mutual Funds Integrity and Fee Transparency Act of
2003'' (HR 2420) that would, among other things, mandate a new
document in which mutual funds would disclose their fees to
investors and directed the Commission to issue a concept release on
issues related to mutual fund transaction cost disclosure. H.R.
2420, 108th Cong. (2003). HR 2420 would also require funds to
disclose their portfolio turnover rate in the new fee disclosure
document and provide a textual explanation of the impact of high
portfolio turnover rates on fund expenses and performance.
Additionally, the Commission has proposed that fund shareholder
reports be required to include, among other things, the costs in
dollars associated with an investment of $10,000, based on a fund's
actual expenses and return for the period. Investment Company Act
Release No. 25870 (Dec. 18, 2002). The Commission is also today
proposing to enhance disclosure regarding breakpoint discounts on
front-end sales loads.
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The Commission is aware of the need for transparency of mutual fund
fees and expenses and committed to improving disclosure of the costs
that are borne by mutual fund investors; but it is mindful of the
complexities associated with identifying, measuring, and accounting for
transaction costs. Thus, the Commission is considering how mutual fund
transaction cost disclosure requirements should be revised to provide
more meaningful information to fund investors. In particular, the
Commission is considering whether mutual funds should be required among
other things to (1) quantify in some meaningful way and disclose some
or all of their portfolio transaction costs without including these
costs in their expense ratios and fee tables; (2) quantify some or all
transaction costs and include them in expense ratios and fee tables;
(3) provide other quantitative information about the level of
transaction costs, or (4) some combination of the above. The Commission
also seeks comment on whether mutual funds should be required to treat
transaction costs, or a portion thereof, as an expense in their
financial statements.
This release invites comment on both the general topic of how to
improve the disclosure of mutual fund transaction costs and a number of
specific questions. For ``yes or no'' questions, please explain the
reasons for your response. For questions with respect to alternatives
for disclosing some or all transaction costs in fund expense ratios,
fee tables or in other numerical formats, please be as specific as
possible about how these alternatives may be accomplished, or why these
alternatives are not feasible. Discussion is encouraged with respect to
specific formulas that should be used, and specific recordkeeping and
operational procedures that should be required in order to implement
numerical disclosures.
The remainder of this release examines a number of major issues
with respect to disclosure of portfolio transaction costs. Section II
describes the different types of portfolio transaction costs and
estimates their magnitude. Section III identifies and discusses various
proposals for additional quantitative disclosures. Section IV discusses
issues related to how funds account for transaction costs and report
them in their financial statements. Section V explains the current
requirements with respect to disclosure and identifies and requests
comment on possible new disclosures related to the level of transaction
costs. Section VI discusses the review of transaction costs by fund
directors.
II. Background
A. Types of Transaction Costs
Broadly defined, a mutual fund's transaction costs include all of
its costs that are associated with trading portfolio securities.\6\
Transaction costs include commissions, spreads, market impact costs and
opportunity costs.
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\6\ See Larry Harris, Trading and Exchanges: Market
Microstructure for Practitioners (2003) at 420-441 (discussing the
components of transaction costs, including explicit and implicit
costs, as well as alternative methods for estimating the magnitude
of transaction costs).
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1. Commissions
Commissions generally refer to charges that a broker collects to
act as agent for a customer in the process of executing and clearing a
trade. Commissions are the only type of transaction cost that can be
measured directly. Measurement is easy because the commission is
separately stated on the transaction confirmation and is paid directly
from fund assets.\7\ Trades for which commissions are paid generally
involve equity securities traded on the exchanges. Equity securities
are also traded on NASDAQ and through dealers. Although historically
NASDAQ trading has been effected primarily on a spread basis, more and
more equity trades are being done as single price riskless principal
trades,\8\ and the cost of these trades is now more frequently charged
and identified as a commission equivalent.\9\ Consequently, it appears
that quantification of commission-type fees on equities has become
easier. In fact, the commission on the average NASDAQ trade (almost 16
basis points) now approaches the commission on the average NYSE trade
(18 basis points).\10\
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\7\ Stephen A Berkowitz and Dennis E. Logue, Transaction Costs:
Much ado about everything, Journal of Portfolio Management (Winter
2001) at 68.
\8\ See Harold Bradley, Senior Vice President, American Century
Investment Management, Statement Before the House Subcommittee on
Capital Markets, Insurance and Government Sponsored Enterprises
(Mar. 12, 2003).
\9\ The Commission has recognized that money managers opting for
certain riskless principal transactions would now be informed of the
entire amount of the market maker's charge for effecting the trade.
See Exchange Act Release No. 45194 (Dec. 27, 2001).
\10\ Justin Schack, Trading Places, Institutional Investor (Nov.
2003) at 32.
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2. Spread Costs
Spread costs are incurred indirectly when a fund buys a security
from a dealer at the ``asked'' price (slightly above current value) or
sells a security to a dealer at the ``bid'' price (slightly below
current value). The difference between the bid price and the asked
price is known as the ``spread.'' Spread costs include both an imputed
commission on the trade and any market impact cost associated with the
trade as discussed below.\11\
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\11\ Funds incur spread costs on trades that are made on a
principal basis (e.g., NASDAQ trades executed from dealer
inventory). Dealer spreads compensate brokers and broker-dealers for
maintaining a market's trading infrastructure (i.e., price discovery
and execution services) and may also reflect the impact of large
orders on the prices of securities. The proportion of these two
components varies among different trades. The market impact cost
component of dealer spreads reflects dealers' inventory management
costs. These costs have a significant impact on the spread between
the dealer's bid (buy price) and ask (sell price). Although spread
costs cannot be directly calculated, they can be estimated with data
collected some time after the trade is executed. See Berkowitz and
Logue, supra note at 65-68.
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3. Market Impact Costs
Market impact costs are incurred when the price of a security
changes as a result of the effort to purchase or sell the security.\12\
Stated formally, market impacts are the price concessions (amounts
added to the purchase price or subtracted from the selling price) that
are required to find the opposite side of the trade and complete the
transaction.\13\
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\12\ See Harris, supra note 6 at 421. The average trade on the
New York Stock Exchange and on NASDAQ is approximately 1,700 shares.
The average order placed by institutions (including mutual funds) is
44,600 shares, according to an estimate from Plexus, Inc. See Wayne
H. Wagner, Chairman, Plexus Group and Senior Vice President, Chase
JPMorgan Chase Co., Statement Before the House Subcommittee on
Capital Markets, Insurance and Government Sponsored Enterprises of
the Committee on Financial Services (Mar. 12, 2003). Basic economics
dictate that, if the supply of a good or service is held steady,
increased demand drives up the price. Large trades have an impact on
price. They ``move the market'' (drive the price up if the fund is
buying; down if the fund is selling.)
\13\ See Berkowitz and Logue, supra note 7 at 67.
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Market impact cost cannot be calculated directly. It can be roughly
estimated by comparing the actual price at which a trade was executed
to prices that were present in the market at or near the time of the
trade.\14\ Impact cost may be reduced by stretching out a trade over a
long time period. The benefit of reduced impact cost may be reduced or
eliminated by an increase in opportunity cost.
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\14\ See Harris supra note 6 at 422-423. Theory suggests
comparing the actual price paid or received to what would have
prevailed had the order never been placed. In practice, however,
only the market prices and bids and offers near the time of the
trade can be observed.
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4. Opportunity Costs
Opportunity cost is the cost of missed trades.\15\ The longer it
takes to complete a trade, the greater the likelihood that someone else
will decide to buy (or sell) the security and, by doing so, drive up
(or down) the price.\16\
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\15\ See Harris, supra note 6 at 421.
\16\ An opportunity cost is incurred when three conditions hold:
(1) The price of a stock rises (falls) after an investor decides to
buy (sell) it, but before he or she is actually able to do so; (2)
the price change is independent of the investor's decision; and (3)
the price change is ``permanent''--i.e., it is caused by the
dissemination of information relevant to the valuation of the asset.
Other factors may influence the price of an asset, such as temporary
liquidity imbalances, but they do not generate opportunity costs.
See Robert A. Schwartz and Benn Steil, Controlling Institutional
Transactions Costs, The Journal of Portfolio Management (Spring
2002) at 43.
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Opportunity cost cannot be measured directly. The joint effect of
market impact and opportunity cost can be estimated by comparing market
prices at the time that the transaction was conceived to the price at
which the transaction was actually executed. Consulting firms have
developed quantitative tools that attempt to estimate these costs for
their clients.\17\
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\17\ See Berkowitz and Logue, supra note 7 at 70.
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5. Magnitude of Transaction Costs
Although estimates of the magnitude of transaction cost and its
components vary, the following estimates are representative. For the
average stock fund, commission costs have been estimated at almost .30%
of net assets \18\ (an amount equal to approximately 20% of the 1.42%
expense ratio of the average long-term mutual fund in 2002); and spread
costs have been estimated at approximately .45% of net assets \19\
(approximately 30% of the average expense ratio.)\20\ Market impact
cost and opportunity cost are more difficult to measure. One study
estimates that total transactions costs (including market impact and
opportunity costs) for large capitalization equity transactions range
from 0.18% to as much as 1% of the principal amount of the
transaction.\21\ Another study estimates that for institutional
investors, under relatively stable market conditions, opportunity costs
may amount to 0.20% of value.\22\
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\18\ Miles Livingston and Edward O'Neal, Mutual Fund Brokerage
Commissions, Journal of Financial Research, Vol. XIX, No. 2 (Summer
1996) at 280. See also, Chalmers, Edelin, and Kadlec, supra note 2
at 2; Rich Fortin and Stuart Michelson, Mutual Fund Trading Costs,
Journal of Investing, Vol. 7, No. 1 (Spring 1998) at 67.
\19\ See Chalmers, Edelen, and Kadlec, supra note 2 at 10.
\20\ Morningstar Principia Pro Database, Apr. 2003 edition.
\21\ See Berkowitz and Logue, supra note 7 at 67.
\22\ See Schwartz and Steil, supra note 16 at 43-44.
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To summarize, commissions are explicit costs, readily identifiable
and quantifiable. Spread, impact, and opportunity costs are implicit
costs. Because the implicit costs, which are difficult to identify and
quantify, can greatly exceed the explicit costs, there is no generally
agreed-upon method to calculate securities transaction costs.\23\
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\23\ ``Transaction cost measurement is as much an art as a
science. It's very difficult to accurately measure implicit trading
costs. Not all companies use the same methodology, and there's no
commonly accepted standards as to how to measure price impact.'' See
Alison Sahoo, SEC Weighs Trading Cost Rule, Seeks Industry Input,
Ignites.com (July 22, 2003) (quoting Ananth Madhavan, managing
director of ITG, a provider of equity-trading services and
transaction research to institutional investors and brokers).
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III. Proposals To Quantify Transaction Costs
During recent years, a number of commentators have argued that
although transaction costs represent a significant portion of the
overall expenses incurred by a mutual fund, current disclosure
requirements fail to provide investors with adequate information about
these costs. Most recently, during hearings held on March 12, 2003 by
the House Committee on Financial Services, Subcommittee on Capital
Markets, Insurance and Government Sponsored Enterprises, and on
November 3, 2003 by the Senate Committee on Governmental Affairs,
Subcommittee on Financial Management, the Budget, and International
Security, several witnesses testified about the opacity of portfolio
trading costs and made suggestions for additional narrative and
quantitative disclosure. Suggested improvements tend to fall into three
broad alternatives that would require funds to: (1) Quantify and
disclose their commission costs; (2) quantify and disclose all of their
transaction costs; or (3) provide other information related to the
level of transaction costs. In this section of the release, we describe
in more detail the alternatives for quantifying transaction costs and
request comment on the alternatives. Alternatives for providing
additional information about the level of transaction costs are
described and comment is requested in Section V of this release.
A. Quantify Commission Costs Only
The dollar amount of commissions paid is easily determined. As
previously indicated, the commission appears on the confirmation of
each transaction and funds already report in their SAIs the aggregate
dollar amounts of commissions paid.
Some commentators have proposed that mutual funds be required to
disclose the commissions they pay to effect securities transactions and
include the result in their expense ratios and fee tables.\24\ They
argue that disclosing portfolio commissions would provide additional
information about the amount of transaction costs that funds incur,
thus permitting investors to make better informed investment decisions.
The average commission paid by institutional investors is about 5 to 6
cents per share, but can range from 1 cent to 12 cents per share.\25\ A
portion
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of these commissions may be used to obtain soft dollar benefits (i.e.,
research and other services as permitted by section 28(e) of the
Securities Exchange Act of 1934) that may benefit the manager. The
limited transparency of soft dollar commissions may provide incentives
for managers to misuse soft dollar services.
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\24\ See John Montgomery, President, Bridgeway Funds, and Gary
Gensler, Former Undersecretary of the Treasury for Domestic Finance
and Author of The Great Mutual Fund Trap, Statements Before the
House Subcommittee on Capital Markets, Insurance and Government
Sponsored Enterprises (Mar. 12, 2003).
\25\ See Harris, supra note 6 at 151. In 1998, the Commission's
Office of Compliance Inspections and Examinations (OCIE) conducted
limited scope on-site inspections of the soft dollar activities of
75 broker dealers and 280 investment advisers and investment
companies. OCIE found the average cost of soft dollar executions was
6 cents per share. See Office of Compliance Inspections and
Examination, SEC, Inspection Report on the Soft Dollar Practices of
Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22,
1998) (available at http://www.sec.gov/news/studies/softdolr.htm)
(``Inspection Report'').
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B. Quantify All Transaction Costs
Some commentators have suggested that mutual funds be required to
quantify and disclose all of the transaction costs that they incur.\26\
This alternative would provide the advantages associated with the
previous alternative (including commissions in the expense ratio) while
eliminating any disadvantages associated with quantifying some, but not
all transaction costs.\27\
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\26\ See John C. Bogle, Founder and Former Chief Executive,
Vanguard Group and President, Bogle Financial Markets Research
Center, Statement Before the House Subcommittee on Capital Markets,
Insurance and Government Sponsored Enterprises (Mar. 12, 2003); and
Mercer Bullard, Founder and President, Fund Democracy, Inc.,
Statement Before the Senate Subcommittee on Financial Management,
the Budget, and International Security (Nov. 3, 2003).
\27\ ``The ability to figure out trading costs is there. When
these companies want internal efficiencies to reduce expenses or
improve sales there's no shortage of money to do that. But as soon
as someone asks them to spend money on what they are charging
shareholders, they bellyache. Trading costs are paid out of
shareholders' money. They should decide what they pay.'' See Sahoo,
supra note 23 (quoting Max Rottersman of fundexpenses.com, a website
that monitors mutual fund costs and expenses).
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This alternative raises the issue of the difficulty of quantifying
spreads, market impacts, and opportunity costs. Consultants and
academics derive transaction cost estimates that include spreads and
market impact costs by using a variety of algorithms to compare the
actual price that was paid in each transaction with the market price
that prevailed at some time before \28\ or after \29\ the transaction
was completed. Perhaps the most all-inclusive way to measure
transaction cost is another method called ``implementation shortfall.''
Implementation shortfall measures the transaction cost of each trade as
the difference between the price of all trades you intend to make
(trades actually made plus intended trades that fail to execute) and
the price that prevailed in the market when each decision to trade was
made.\30\
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\28\ A ``before trade'' measure compares the actual price of
each trade with the price that prevailed in the market before the
transaction was completed. See Andre F. Perold, The Implementation
Shortfall: Paper vs. Reality, Journal of Portfolio Management
(Spring 1988) at 8.
\29\ In an ``after trade'' measure, the market price might be
today's closing price, tomorrow's closing price, some other price in
effect after the fund completed the trade, the average of the high
and the low for the day, or a weighted average of all prices at
which market participants transacted on that day. See Perold, supra
note 28 at 7.
\30\ The concept of ``implementation shortfall'' was introduced
by Treynor in 1981. See Jack L. Treynor, What Does it Take to Win
the Trading Game?, Financial Analysts Journal (Jan.-Feb. 1981). at
55-60; see also Perold, supra note 28 at 8. Implementation shortfall
is defined as a measure of the degree to which execution, market
impact and opportunity costs prevent the investor from taking
advantage of his or her stock selection skills. See Perold, supra
note 28 at 5-6. Implementation shortfall can be interpreted as the
difference in value between an actual portfolio and a corresponding
paper portfolio. A paper portfolio is an imaginary portfolio that is
constructed on paper to see what would happen if certain trades were
actually made. To measure transaction costs, a trader must specify a
benchmark price at which he buys or sells securities for his paper
portfolio. The difference in value between the actual portfolio and
the corresponding paper portfolio measures the trader's cost of
implementing trading decisions relative to this benchmark. Since
implementation is generally accomplished at a cost, paper portfolios
typically earn better returns than the corresponding actual
portfolios. Harris, supra note 6 at 426. Leinweber illustrates the
implementation shortfall concept by noting that from 1979 to 1991
stocks classified as ``Group 1'' by Value Line had an annualized
return of 26.3% while the Value Line mutual fund that contained the
same stocks returned only 16.1%. The difference between the paper
return and the actual portfolio return is the cost of trading. David
J. Leinweber, Using Information from Trading in Trading and
Portfolio Management, 4 Journal of Investing, No. 1 (1995) at 40.
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With respect to the before trade and after trade methods, a common
standard would need to be chosen from among the wide variety of
estimation techniques that are used, opportunity costs would remain
unaccounted for, and some measures in this category may be vulnerable
to being ``gamed.''\31\
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\31\ For example, because a before trade measure compares the
actual price of each trade with the market price in effect before
the transaction was completed, the market price is known in advance.
A trader working on behalf of a fund could ``manufacture'' low
transaction costs if, after each decision to trade is made, the
trader would wait to take action on the order list, implement only
the buy orders for which prices have fallen since the receipt of the
order, implement only the sell orders for which the prices have
risen, and dismiss the rest of the orders as ``too expensive'' to
execute. See Perold, supra note 28 at 7-8.
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The advantages of the implementation shortfall method are that it
includes all trading costs and is not vulnerable to being gamed.
However, there is no generally accepted manner to calculate a
portfolio's implementation shortfall. To monitor performance and comply
with their best execution responsibilities, many fund advisers already
gather a substantial amount of data about transaction costs and
execution quality.\32\ Of course, there may be substantial differences
in the types of data that fund advisers currently gather that would
require changes to their systems. However, there may be a fair amount
of uniformity, at least on the general types of information (e.g.,
trade decision time, time orders are given to brokers, trade execution
time and price, etc.) that fund advisers maintain.
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\32\ ``Virtually all the major institutions have a transaction-
cost measuring system in place. They compare their actual execution
costs to pre-trade benchmarks from models or peer comparisons from
different firms. That puts pressure on the trading desks to control
costs. So the guys who aren't doing it are being left behind.''
Sahoo, supra note 23 (quoting Ananth Madhavan). ``* * * [M]ore
pension funds and investment managers are measuring transaction
costs--either by using proprietary systems or third party services *
* *. Since the wrenching bear market of 2000-'02, institutions have
learned that transaction costs can be a significant drag on
performance, and they have begun managing them as intently as they
research stocks.'' Schack, supra note 10, at 32.
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C. Quantify the Effect of Daily Decisions to Trade
Another, more inclusive alternative for measuring transaction costs
would capture the combined effect of transaction costs and gains and
losses from short term trading. This ``trade effect'' measure would
reflect the annual average daily difference between the actual value of
the portfolio as of the close of each trading day and the hypothetical
value of the portfolio if no trades had been made that day.
Trade effect is easy to measure in practice. It is equal to the
total mark-to-market profits or losses on the security purchases and
sales made by the fund. For a purchase, the mark-to-market profits or
losses are computed by multiplying the total quantity traded in the
security times the difference between the volume-weighted average fill
price and the price at the end of the period over which the profits or
losses are measured. For a sale, it is the negative of this
quantity.\33\
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\33\ For example, a mutual fund purchases 500 shares of ABC
Company at a volume-weighted average fill price of $19. The price of
the security at the end of the measurement period is $20. The mark-
to-market profit or loss associated with this trade would be the
difference between the fill price and the measurement price (-$1)
times the number of shares transacted (500), or -$500.
Alternatively, a mutual fund sells 500 shares of XYZ Company at a
volume-weighted average fill price of $15. The price of the security
at the end of the measurement period is $17. The mark-to-market
profit or loss associated with this trade would be the negative of
the difference between the fill price and the measurement price
(+$2) times the number of shares transacted (500), or $1,000. In
this example, the cost of trading--the trade effect--would be $500
(-$500 + $1,000), indicating that the trading was not beneficial. If
assets for the measurement period were $100,000, the trade effect
would be 0.5%.
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[[Page 74824]]
For disclosure purposes, each fund could be asked to sum these
mark-to-market profits and losses across all trades on a given day.
Funds would divide this sum by total assets for that day and report on
an annual basis the average of this ratio across all trading days.
Trade effect includes all realized costs of trading--commission,
spread and price impacts--plus any short-term trading profits or losses
incurred as a result of the timing of the trade. Funds produce short-
term trading profits if they can successfully capitalize on short-term
price changes, for example, when they buy before prices rise. They
incur short-term trading losses when they poorly time their trades, for
example, when they buy before prices fall.
Investors may benefit from disclosure of short-term trading impact
information because it would allow them to better understand the
benefits and costs associated with fund portfolio trading. This
information may particularly help investors interpret fund turnover.
Although high turnover generally is correlated with poor performance
due to excessive transaction costs and poor timing, high turnover may
be desirable for funds that can implement profitable short-term trading
strategies. Presently, investors lack the information necessary to
meaningfully discriminate among funds on this basis. Trade effect
disclosure may allow investors to determine the extent to which fund
performance--for better or worse--is due to its trading activities.
If the Commission were to mandate trade effect disclosure, it would
have to determine the period over which funds would measure their trade
effect mark-to-market profits and losses. It might seem most natural to
measure trade effect over the trading day on which each trade occurred
by comparing trade prices to trade day closing prices. However, this
comparison could cause some managers to shift their trading towards the
end of the trading day to minimize their reported trade effect. To
reduce such incentives, trade effect could be measured by comparing
trade prices to closing prices on the next trading day.\34\
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\34\ As noted above, trade effect measures the combined effect
of transaction costs and short-term trading profits (or losses). The
use of next day closing prices instead of same day closing prices
would increase the importance of the short-term trading profits in
the determination of the trade effect measure. Although variation in
trade effect due to unpredictable market fluctuations would
increase, averaging over many securities and over all days in the
year would largely eliminate the impact of such fluctuations.
Moreover, since most funds simultaneously buy and sell when
effecting portfolio adjustments, the effects of unpredictable market
fluctuations on the mark-to-market profits for buy and sell trades
often would offset each other.
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D. Sell-Side Alternatives
Thus far, the discussion in this release has focused primarily on
the disclosure by mutual funds of their transaction costs and execution
quality. The Commission also wishes to request comment on whether
disclosure by markets or broker-dealers of their execution quality for
large, institutional orders would be helpful to funds in evaluating
execution costs. For example, broker-dealers handling large orders
potentially could be required to disclose statistics that compare the
prices at which their orders are executed with the quotes for a
security at the time they received the order. To enhance their
comparability, the statistics could be divided into categories based on
the size of the order compared to the average daily trading volume in
the security. Similar disclosure could be required of other venues that
directly receive and execute institutional orders, such as floor
brokers, specialists, and electronic trading venues. Such sell-side
disclosure could represent one part of a comprehensive approach that
attempted to measure transaction costs throughout the trading cycle.
Standardized market statistics, which would encompass orders from many
different institutions, potentially could provide benchmarks for
execution quality that might assist fund managers and their boards in
evaluating the execution quality obtained from different broker-
dealers. For example, such statistics might be helpful in evaluating
the execution quality obtained from affiliated or related broker-
dealers compared to that obtained from those that are independent of
the fund.\35\
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\35\ For a fuller discussion of fund director's review of
transaction costs, see Section VI of this Release, ``Review of
Transaction Costs by Fund Directors.''
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* * * * *
General Questions About Quantifying Transaction Costs
1. Is investor decision-making harmed because investors lack
numerical information about mutual fund transaction costs?
2. What would be the best way to provide investors with additional
numerical information about the amount of transaction costs that mutual
funds incur? Would the information most appropriately be located in the
prospectus, the SAI, or in another disclosure document?
Questions About Quantifying Commissions and Spreads
3. Would a requirement to quantify (express as a percentage) and
disclose brokerage commissions, but not other transaction costs provide
useful information to fund investors? If funds are required to quantify
and disclose their brokerage commissions, should the number be included
in fund expense ratios and fee tables?
4. Does the increased use of riskless principal trades on NASDAQ
make it easier to quantify the cost of NASDAQ trades? What proportion
of NASDAQ trades are subject to commission-equivalent fees?
5. Would quantifying commissions mislead investors because it would
result in a number that includes some transaction costs and excludes
others? Please explain the reasons for your answer.
6. If the answer to question 5 is yes, would the concern be
alleviated if funds were required to quantify commissions and provide
investors with disclosure that details the portion of trades that are
performed on a commission basis; spread basis; or some other basis
(e.g., directly from an issuer)?
7. What effect, if any, would a requirement to quantify commissions
have on the incentives of fund managers with respect to (1) use of
principal versus agency transactions; and (2) use of soft dollar
transactions?
8. Could any possible adverse effects identified in questions 5 and
6 be mitigated or eliminated by requiring funds, in addition to
reporting their commission costs, to estimate the spread cost of their
principal trades (for example, by imputing to principal trades the
fund's average commission rate on agency trades)? If yes, should this
number be included in fund expense ratios and fee tables?
9. Alternatively, can the portion of spread cost that represents
payment for executing a trade be measured separately from the portion
of the spread that represents the market impact cost associated with
that trade? If yes, should this number be included in fund expense
ratios and fee tables?
Questions About Quantifying All Transaction Costs
10. Would a requirement to quantify all transaction costs provide
useful information to fund investors? Would a requirement to quantify
all transaction costs, except opportunity costs be a better
alternative? If you advocate that we mandate either of these
alternatives, please explain as specifically as possible, how the
alternative should be
[[Page 74825]]
implemented. Please discuss the specific algorithms, formulas,
definitions, recordkeeping requirements, and internal control
requirements that should be used. Commenters are encouraged to address
the following specific topics:
A. How should funds measure their spread costs?
B. How should funds measure their market impact costs?
C. How should funds measure their opportunity costs?
D. Should spread, market impact and opportunity costs be measured
trade-by-trade or for all transactions?
E. Should spread, market impact and opportunity costs be measured
absolutely or relative to a benchmark?
F. Should this number be included in fund expense ratios and fee
tables?
11. Would the trade effect measure provide useful information to
investors, and if so, should we require its disclosure? If the
Commission mandated trade effect disclosure, should trade effect be
measured with respect to same day closing prices or next day closing
prices?
12. More generally, if the Commission were to choose to require
disclosure of only one transaction cost measure, which measure should
it be?
* * * * *
IV. Accounting Issues
Under generally accepted accounting principals, most portfolio
transaction costs are either included as part of the cost basis of
securities purchased or subtracted from the net proceeds of securities
sold and ultimately are reflected as changes in the realized and
unrealized gain or loss on portfolio securities in the fund's financial
statements.\36\ Unfortunately, this accounting treatment provides a
mutual fund shareholder with an opaque view of portfolio transaction
costs in a fund's financial statements.\37\ One effect of this lack of
transparency is that it has impaired the ability of investors to
evaluate the use of fund assets to obtain research services (as that
term is defined in section 28(e) of the Securities Exchange Act of
1934) that are paid for through commissions or spreads.
---------------------------------------------------------------------------
\36\ For example, if a mutual fund purchases 1 share of XYZ
Company at a price of $10 with a commission of 5 cents, the mutual
fund will record the cost of that security as $10.05. However, the
mutual fund will record the security on its statement of assets and
liabilities at its market value, for example, $10.03. The fund will
then record the difference between the cost basis ($10.05) and the
market value ($10.03) as unrealized gain or loss, in this case, an
unrealized loss of 2 cents. Therefore, the portfolio transaction
costs are not reflected directly as expenses of the fund, but are
reflected in the statement of operations as changes in the realized
or unrealized gain or loss on portfolio securities. See AICPA Audit
and Accounting Guide for Investment Companies, paragraph 2.40 (May
1, 2002).
\37\ Regardless of whether transaction costs are included in the
costs basis/settlement proceeds of securities transactions or
separately identified as operating expenses of the fund, the total
return of the fund remains the same. Total return is calculated
based on the net asset value of the fund, which would not be
impacted by the alternatives in recognizing transaction costs. See
Item 9 of Form N-1A. Form N-1A is the registration form used by
open-end investment companies to register under the Investment
Company Act of 1940 and to offer their shares under the Securities
Act of 1933 [15 U.S.C. 77a].
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The component of commissions that represent execution and clearing
costs are the equivalent of acquisition or disposition costs incurred
on physical assets and current accounting principles dictate that they
be included in the cost basis of securities purchased or in the net
proceeds from securities sold.\38\ However, the component of
commissions that represent the costs of services is conceptually an
operating expense of a fund and should not be included in the cost
basis of securities purchased or in the net proceeds from securities
sold.\39\
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\38\ See Financial Accounting Standards Board Statement of
Financial Accounting Concepts No. 2, Qualitative Characteristics of
Accounting Information.
\39\ See Financial Accounting Standards Board Statement of
Financial Accounting Concepts No. 5, Recognition and Measurement in
Financial Statements of Business Enterprises.
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We have attempted to improve the transparency of financial
reporting when reliable information is available. For example, the
aggregate value of all fund operating expenses paid for by brokers in
brokerage offset arrangements are identifiable and measurable, even if
the brokerage offset credits cannot be allocated to individual trades.
Accordingly, we adopted a rule under Regulation S-X in 1995 that
requires a mutual fund to record the value of services received under
brokerage-offset arrangements as an expense.\40\ The practical result
is that the portion of commission or spread cost that can be reliably
identified and measured and that also represents operating expenses of
the fund is reflected in the expense ratio and in fund expenses.\41\
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\40\ See Rule 6-07(2)(g) of Regulation S-X [17 C.F.R. 210.6-
07(2)(g)]. Prior to adoption of this rule, funds would report fund
expenses, such as expenses for transfer agency, custody, and other
services net of direct payments made by brokerage firms on behalf of
funds under brokerage offset arrangements. Rule 6-07(2)(g) requires
these fund expenses reflect the total amounts paid to fund service
providers whether directly paid by the fund or by another entity on
its behalf. The fund is allowed to show after total fund expenses
the amount of those expenses paid by the brokerage firms. This
presentation results in a gross-up of income and expenses in the
statement of operations; however, it provides transparency to
shareholders on the impact of these arrangements on the fund's
financial statements. Additionally, this presentation allows the
expense ratio to properly reflect a component of commission/spread
costs as an expense.
\41\ When we adopted this requirement, we also requested comment
on whether the cost of research services provided by broker-dealers
should be expensed. Many commentators pointed out the difficulty of
allocating research received by an adviser among accounts when the
brokerage of those accounts is used to acquire the research. Some
commentators, however, supported the additional disclosure of
research soft dollar practices. See Investment Company Act Release
No. 21221 (July 21, 1995).
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We are considering whether all transaction costs can be and should
be captured in fund expense ratios and fee tables contained in a fund's
prospectus. We also are considering whether the cost information
obtained would be reliable and relevant for financial reporting
purposes or whether alternatively, some subset of transaction costs
(e.g., all non-execution and clearing costs) can be reliably measured
and expensed for financial reporting purposes. We may conclude that the
standard for including these costs in the fee table is different than
the standard for including these costs in the fund financial statements
thereby creating a discrepancy between the two measures. If we conclude
transaction costs or some subset of transaction costs should be
included in fund financial statements, those statements would not be
comparable to other similar entities, such as pension funds, hedge
funds, and other investment vehicles. We are interested in the
perspectives of fund investors and fund financial statement preparers
on the desire for and feasibility of including some or all of this
information in the prospectus and the fund financial statements.
* * * * *
Questions About Accounting Issues
13. Would it be appropriate to include some or all transaction
costs in fund expense ratios and fee tables without accounting for
these items as an expense in fund financial statements?
14. Would it be feasible to account for some or all transaction
costs as an expense in fund financial statements? If it is not feasible
to reliably measure market impact and opportunity costs, should we
still require that commission costs be expensed? If yes, should the
requirement apply to all commission costs or only those commission and
spread costs that do not relate to the execution and clearing of a
portfolio transaction (i.e., soft dollars)? If it is not feasible to
reliably measure all research costs, should we still expense those
costs that can be reliably measured (i.e., payments to third parties
for research)?
[[Page 74826]]
15. Are mutual funds and their managers better able than they were
in the past to track the portion of commission costs that purchase
research services from brokers? Has the improvement been sufficient to
make it feasible for us to require funds to expense these items in
their financial statements? Since soft dollars are earned based on
complex-wide trading activity, how should research and other non-
execution costs be allocated among funds? Can soft dollars be traced to
individual portfolio transactions? (This would entail adjusting the
basis of the securities purchased in those transactions for the portion
of the commission cost that was used to purchase research services.)
Alternatively, should an aggregate adjustment (not specified to a
particular portfolio transaction) be made to realized and unrealized
gain or loss? If funds and their managers are not yet capable of
tracking the portion of commission costs that purchase research
services from brokers, what factors continue to prevent funds and
managers from developing this capability?
* * * * *
V. Alternatives That Provide Additional Information About the Level of
Transaction Costs
A. Existing Disclosure Requirements
1. Portfolio Turnover
All mutual funds (except money market funds) provide investors with
information about two items that are related to transaction costs ``
portfolio turnover rate and dollar amount of brokerage commissions.\42\
Funds disclose in their prospectuses the annual rate of portfolio
turnover that they have incurred during the last five fiscal years.\43\
Portfolio turnover rate measures the average length of time that a
security remains in a fund's portfolio.\44\ The requirement to disclose
portfolio turnover rate is premised on the observation that a fund's
transaction costs tend to be highly correlated with its turnover rate,
other factors held equal.\45\ Thus, by comparing turnover rates,
investors can obtain an indication of how transaction costs are likely
to vary among different funds. The advantage that turnover rate (an
indirect indicator of fund transaction costs) has over the dollar
amount of brokerage costs (a more direct measure) is that turnover rate
is less affected by the asset size of a fund. For example, a fund with
assets of $1 billion is likely to pay many more dollars of brokerage
commissions than a fund with assets of $100 million, even if their
turnover rates are identical.
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\42\ Money market funds purchase and sell securities on a
principal basis. Transaction costs for these securities are embedded
in the purchase price or sale proceeds and are not separately
stated.
\43\ See Item 9 of Form N-1A.
\44\ For example, a fund that has a portfolio turnover rate of
100% holds its securities for one year, on average. A fund with a
portfolio turnover rate of 200% holds its securities for six months,
on average.
\45\ See, e.g., Livingston and O'Neal, supra note 18 at 283;
Fortin and Michelson, supra note at 67. But see, Chalmers, Edelen,
and Kadlec, supra note 2 at 2 (``Turnover is likely to be an
unreliable proxy for funds trading expenses because it does not
account for heterogeneity in the per-unit costs of trading an asset.
For example, an uninformed manager that frequently trades assets
with a low cost-per-trade may incur lower trading expenses than an
uninformed manager who infrequently trades assets with high cost-
per-trade.'')
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2. Dollar Amount of Commissions Paid
In addition to providing their portfolio turnover rates, funds are
required to disclose in their prospectus whether they may engage in
active and frequent trading of portfolio securities to achieve their
investment strategies. If so, funds must explain the tax consequences
to shareholders of the increased portfolio turnover, and how the
trading costs and tax consequences may affect investment
performance.\46\
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\46\ See Instruction 7 to Item 4(b) of Form N-1A.
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Funds (with the exception of money market funds) also must disclose
in their SAIs the dollar amount of brokerage commissions that they have
paid during their three most recent fiscal years.\47\ Brokerage
commission amounts, although they must be interpreted carefully, can
nevertheless provide useful information to fund investors. This
disclosure informs investors of the magnitude of the fund's overall
assets that are expended on commissions.
---------------------------------------------------------------------------
\47\ See Item 16(a) of Form N-1A.
---------------------------------------------------------------------------
B. Improving Disclosure Related to the Level of Transaction Costs
Another set of alternatives for improving mutual fund transaction
cost disclosure consists of approaches aimed at improving current
transaction cost related disclosures or adding new types of disclosure
that would provide information that is more meaningful and
understandable to the average investor.
1. Disclose Transaction Costs in Terms of Rated Categories
One commentator has suggested transaction costs (including
commissions, spreads, and market impact costs) could be disclosed in
terms of rated categories, instead of as part of the expense ratio or
as a stand-alone ratio. The commentator suggested funds would
categorize their trading costs as either very high, high, average, low
or very low. The commentator acknowledged this disclosure might be a
rough estimate, but a ``rough estimate was better than no estimate at
all.'' \48\
---------------------------------------------------------------------------
\48\ See Statement of Wayne H. Wagner, supra note 12.
---------------------------------------------------------------------------
Each fund would be compared to an industry standard. In order for
such a comparison to be made, a transaction cost measure would have to
be developed. In addition, we would have to determine whether any
comparison should be against other funds generally or only against
similar funds. For example, the transaction costs of an equity fund are
likely not comparable to transaction costs of a fixed-income or money
market fund.
2. Portfolio Turnover
Another possible approach would be to require funds to give greater
prominence to the portfolio turnover ratio.\49\ Portfolio turnover can
be calculated easily by all funds. The ratio is simple and easy to
understand and readily comparable among funds. If portfolio turnover is
highly correlated with transaction costs, then the portfolio turnover
ratio may be a good proxy for these costs.\50\ The advantages of being
able to easily calculate, understand, and compare portfolio turnover
rates may justify any imprecision in their correlation to transaction
costs.
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\49\ HR 2420 would require funds to disclose their portfolio
turnover rate in a new document in which mutual funds would disclose
their fees to investors.
\50\ See supra note 45.
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3. Information About Average Net Flows
Another approach to providing information about transaction costs
is to provide additional information about the sale and redemption of
fund shares. The sale and redemption of fund shares often generates
portfolio transaction costs that all fund investors must bear. Sales of
fund shares often lead to security purchases as new monies are invested
in the fund's portfolio. Redemptions often lead to security sales to
raise money to pay for redemptions. To the extent that sales and
redemptions do not offset each other, the net difference ultimately
will generate portfolio transactions. These transactions usually incur
transaction costs that all investors (in the case of net sales) or all
remaining investors (in the case of net redemptions) must bear.
Investors therefore may be interested in the average level of net
flows into and out of funds. The disclosure of average daily net flow,
measured as a fraction of total assets, therefore might help investors
predict the losses that they
[[Page 74827]]
will bear when holding funds that other traders trade. This measure may
provide investors with information about whether the other shareholders
in the fund tend to be long-term or short-term investors, and may allow
them to gauge the portfolio transaction costs generated by short-term
investors. This measure also would help investors understand the extent
to which a fund is used by other investors for short-term trading--
i.e., market timing.
4. Other Narrative Disclosures
Another possible approach is to require a discussion of transaction
costs and portfolio turnover in the prospectus, the report to
shareholders, or in another disclosure document. Currently, funds are
required to discuss the impact of active and frequent portfolio
trading, which results in a higher portfolio turnover ratio, if it is a
principal investment strategy. The Commission could require that all
funds discuss the impact that their management style would have on
portfolio turnover. Funds also could be required to discuss the impact
on portfolio transaction costs by: trading in various types of
securities in which the fund will invest; markets in which they will
invest (e.g., on an exchange or through over-the-counter transactions,
or in foreign or domestic markets); and the portfolio management
strategies that a fund's adviser will employ. In addition, the
Commission could require a fund to disclose the portfolio turnover rate
that the fund would not expect to exceed.
5. Brokerage Costs and Average Commission Rate per Share
The Commission could require that the information on brokerage
costs that is currently included in the SAI be moved to the fund
prospectus and prominently displayed with the portfolio turnover
information to give shareholders a more complete understanding of the
underlying transaction costs of the fund. Another possibility would be
to reinstate some form of average commission rate per share
disclosure,\51\ with appropriate revisions to make it more meaningful
than the previously eliminated disclosures of such information in the
fund's financial highlights table.
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\51\ In 1995 the Commission amended Form N-1A to require funds
to disclose in the financial highlights table their average
commission rate per share. See Investment Company Act Release No.
21221 (July 21, 1995). This amount was calculated by dividing the
total dollar amount of commissions paid during the fiscal year by
the total number of shares purchased and sold during the fiscal year
for which commissions were charged. In 1998 the Commission
eliminated this requirement in the belief that the fund prospectus
is not the most appropriate document through which to make this
information public. See Investment Company Act Release No. 23064,
(Mar. 13, 1998). The Commission noted that industry analysts had
informed the staff that average commission rate information is only
of marginal benefit to them and to typical fund investors, and that
the analysts support the view that these rates are technical
information that typical investors are unable to understand.
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6. Disclosure of Gross Returns
Up to this point in the release, we have described the many sources
of costs incurred by fund investors. We could require an alternative
disclosure that captures indirectly the total cost of investing in
funds. Funds could report the return on their investments prior to all
identifiable costs along with the investment return after such costs
have been deducted. By reporting both measures side by side, investors
could get a reasonable idea of how much they are paying for the return
they receive.
Current Commission regulations mandate the disclosure of the
returns that funds generate after fees and expenses (standardized
returns).\52\ These standardized returns differ from the gross returns
generated by the fund's portfolio manager.\53\ Gross returns are the
returns that investment managers produce while standardized returns are
the returns that are available to shareholders.
---------------------------------------------------------------------------
\52\ See Item 21(b)(1) of Form N-1A.
\53\ Gross return refers to the aggregate performance of the
holdings of a portfolio.
---------------------------------------------------------------------------
Gross returns are generally higher than standardized returns
because the standardized returns reflect the loads, fees, expenses, and
other charges that shareholders pay to obtain and maintain their
investments. Dilution due to market timing may also cause standardized
returns to be lower than the associated gross returns.
If gross returns were disclosed to investors, they could compare
the returns produced by their managers with the standardized returns.
Investors would be able to evaluate the efficiency of fund management
by examining the difference between these two returns. In particular,
they would be able to determine how much of the portfolio return they
will actually receive on a net basis.
The disclosure of gross returns would also allow investors to
compare the performance of investment managers on an equivalent basis.
Such comparisons now require that investors take into account
differences across funds, such as loads, fees, expenses, and dilution.
Although loads, fees, and expenses are now disclosed, dilution caused
by portfolio trading is not. Accordingly, investors cannot now compare
investment managers on a completely equivalent basis.
* * * * *
Questions About Improving Disclosure Related to the Level of
Transaction Costs
16. Are there ways to provide a rough estimate of transaction
costs, or develop a scheme to categorize these costs (for example,
``very high,'' ``high,'' ``average,'' ``low,'' or ``very low'') under
general guidelines set by the Commission that would mitigate the
difficulties involved in coming up with a more precise measure, and yet
still provide useful information to investors? Could such an approach
produce results that are consistent enough to permit meaningful
comparison among funds? If yes, please provide specific suggestions.
17. In general, do the current disclosure requirements relating to
transaction costs described in this section of the release provide
investors with adequate information? If not, what additional
information should funds provide? Would one or more of the alternatives
described in this section provide useful information to investors, or
would the alternatives lengthen the prospectus while providing no real
benefit? If one or more of these alternatives would provide meaningful
information, would the information most appropriately be located in the
prospectus, the SAI, the report to shareholders, or in another
disclosure document?
18. Does existing portfolio turnover disclosure provide useful
information about transaction costs? If additional narrative disclosure
concerning portfolio turnover and its relationship to transaction cost
is needed, what information should be required?
19. Does the existing requirement to disclose the dollar amount of
commissions paid provide investors with meaningful information about
transaction costs? How can the existing requirement be improved?
20. Would an average daily net flow measure provide useful
information to investors?
21. Should the Commission consider policies to encourage funds to
charge purchasers and redeemers of fund shares a fee payable to the
funds to compensate existing and remaining investors for the costs they
bear when their funds accommodate the purchases and redemptions of
other investors? If yes, should the Commission consider requiring funds
to disclose how they compute these fees, if they require them; and why
they do not require these fees, if they do not?
[[Page 74828]]
22. Should the requirement to disclose average commission rate per
share be reinstated, in either its original form or in a revised form?
If you advocate that it be reinstated in a revised form, please provide
specific suggestions.
23. Is ``transaction costs'' as described in this release a useful
concept, or would it be more useful for investors to see the effect of
all costs combined, for example, by showing the following:
[sbull] Gross or ``pure'' portfolio return;
[sbull] Net return to shareholders; and
[sbull] The resulting difference?
24. If it would be useful for investors to see the effect of all
costs combined, could funds calculate and report the gross or ``pure''
portfolio return, net return to shareholders and the resulting
difference on an annual basis?
25. Should the Commission require disclosure of gross returns? If
so, what definition would be most useful? Of what benefit would these
returns be to investors? How expensive would it be for funds to compute
these returns?
26. Would the disclosure of gross returns allow investors to better
identify dilution due to market timers?
27. If portfolio returns are to be disclosed, how should the
returns be adjusted for fund flows into and out of the portfolio?
Should they be computed using internal rate of return methods; time-
weighted average methods; or should other methods be used?
28. If portfolio returns are to be disclosed, should these returns
only be disclosed, or should the differences between these returns and
the shareholder returns be disclosed?
29. Where should these returns or return differences be disclosed,
and how should they be described?
* * * * *
VI. Review of Transaction Costs by Fund Directors
Although a mutual fund's investment adviser has an obligation to
seek the best execution of securities transactions arranged for or on
behalf of the fund, the adviser is not necessarily obligated to obtain
the lowest possible commission cost. The adviser's obligation is to
seek to obtain the most favorable terms for a transaction reasonably
available under the circumstances.\54\ Given the fact that portfolio
transactions costs can be substantial and that they involve the use of
fund assets, portfolio transaction costs must be a significant issue
for consideration by fund directors. The transaction costs incurred by
a mutual fund are also generally reviewed by the fund's board of
directors because section 15(c) of the Investment Company Act requires
a fund's board to request and review such information as may reasonably
be necessary to evaluate the terms of the advisory contract between the
adviser and the fund. Even if the investment adviser obtains best
execution, research, distribution, and other services purchased by the
adviser with the fund's brokerage bear on the reasonableness of the
fund's management fee because the research, distribution and other
services may otherwise have to be purchased by the adviser itself,
resulting in higher expenses and lower profitability for the adviser.
Therefore, for example, mutual fund advisers that have soft dollar
arrangements provide their funds' boards with information regarding
their soft dollar practices.\55\
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\54\ See Securities Exchange Act Release No. 23170 (Apr. 23,
1986).
\55\ See Section 15(c) of the 1940 Act. See also, Inspection
Report, supra note 25.
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In evaluating the use of commissions, fund directors also consider
the appropriateness of entering directed brokerage arrangements. Under
a directed brokerage arrangement, the fund asks the investment adviser
to direct securities transactions to a particular broker that has
agreed to provide services, pay for services provided by others, or
make cash rebates to the fund. Funds typically enter into directed
brokerage arrangements to offset fund expenses, such as audit, legal,
and custodial fees. Although directed brokerage does not involve the
conflicts posed by soft dollars, it does raise issues related to how a
fund's assets are being expended and other issues, including
disclosure.\56\
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\56\ All advisers, including the investment advisers of mutual
funds, have an obligation to act in the best interests of their
clients and to place client interests before their own. They also
have an affirmative duty of full and fair disclosure of all material
facts to their clients. See 15 U.S.C. 80b-6 (2000) (Section 206 of
the Investment Advisers Act of 1940); S.E.C. v. Capital Gains
Research Bureau, 375 U.S. 180 (1963). Some of the funds that engage
in directed brokerage disclose the practice in the prospectus, the
SAI, and/or the annual report to shareholders. Others use the
footnotes to the financial statements to make the disclosure. In
1995, the Commission adopted accounting rules which require funds to
report all expenses gross of off-sets or reimbursements pursuant to
a directed brokerage arrangement. See supra note 40. HR 2420 would
create a specific fiduciary duty for fund boards to review soft
dollar and directed brokerage arrangements, as well as require an
annual report to the board on soft dollar and directed brokerage
payments, as well as summary disclosure in annual reports to
shareholders regarding the report to the board in these areas.
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* * * * *
Questions About Board Review of Transaction Costs
30. Are existing requirements for board review of transaction costs
adequate? If they are not adequate, how can they be improved?
31. Should boards be required to receive reports with mandated
information regarding soft dollars and directed brokerage payments?
Should investors be provided periodically with a summary of these
reports?
32. One problem in evaluating execution cost measurements is in
identifying a standard of comparison. It may be difficult for fund
directors to assess the fund's execution performance statistics in a
vacuum, without comparison with other funds' statistics. Should the
Commission or other independent body collect these statistics from
similar funds and make available aggregate statistics for comparison
purposes?
33. Should fund advisers be required to provide fund boards with an
internal allocation of their uses of brokerage commissions, indicating
the amounts and percentage used by the adviser to obtain execution
services and soft dollar benefits, specifically detailing the types and
amounts of the various kinds of benefits? Should there be separate
allocations among types of research, such as research produced by
underwriters, or other broker-dealer affiliates?
* * * * *
In conclusion, the Commission believes that shareholders need to
better understand a fund's trading costs in order to evaluate the costs
of operating a fund. As outlined above, the Commission intends to
examine what steps can be taken to improve the disclosure of
transaction costs in order to make the information more useful and
understandable to the average investor.
By the Commission.
Dated: December 18, 2003.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-31695 Filed 12-23-03; 8:45 am]
BILLING CODE 8010-01-P