17172 Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules

1See, e.g., Disclosure of Mutual Fund

Performance and Portfolio Managers, Investment

Company Act of 1940 (‘‘Investment Company Act’’)

Rel. No. 19382 (Apr. 6, 1993) [58 FR 19050 (Apr.

12, 1993)] (requiring mutual fund prospectuses or

annual reports to discuss performance and provide

line graph comparing fund performance to that of

an appropriate market index over the last ten fiscal

years; financial highlights table of prospectus

revised to include total return information and

generally to provide investors with information

showing the performance of funds on a per share

basis); Registration Form for Closed-End

Management Investment Companies, Investment

Company Act Rel. No. 19115 (Nov. 20, 1992) [57

FR 56826, 56829 (Dec. 1, 1992)] (improvements to

financial highlights table for closed-end funds; fee

table providing standard format for expense

information required in closed-end fund

prospectuses); Advertising by Investment

Companies, Investment Company Act Rel. No.

16245 (Feb. 2, 1988) [53 FR 3868 (Feb. 10, 1988)]

[hereinafter ‘‘Rel. 16245’’] (mutual fund

advertisements and sales literature containing

performance data required to include uniformly

computed performance data); Consolidated

Disclosure of Mutual Fund Expenses, Investment

Company Act Rel. No. 16244 (Feb. 1, 1988) [53 FR

3192 (Feb. 4, 1988)] (fee table required in mutual

fund prospectuses).

2The SEC requested comment on methods for

disclosing risk in 1993 when it proposed rule

amendments that would have given investors the

option of purchasing mutual fund shares based on

a short form prospectus. Off-the-Page Prospectuses

for Open-End Management Investment Companies,

Investment Company Act Rel. No. 19342 (Mar. 19,

1993) [58 FR 16141, 16145 (Mar. 25, 1993)]

[hereinafter ‘‘Rel. 19342’’]. In particular, the SEC

asked whether the short form prospectus should be

required to contain a standardized presentation of

the degree and kind of risk presented by a mutual

fund relative to other mutual funds. A limited

number of comments were received on this topic,

with the comments being almost evenly divided

whether standardized risk disclosure should be

required. See Summary of Comment Letters

Relating to Proposed Rule 482(g) Made in Response

to Investment Company Act Release No. 19342, File

No. S7–11–93, Jan. 27, 1994, at 17–18 [hereinafter

‘‘Summary of Comments: Rel. 19342’’].

3Risk factors include those peculiar to the fund

and those that apply generally to funds with similar

investment policies and objectives or, in the case

of closed-end funds, similar capital structures or

trading markets. Item 4(c), Form N–1A, & Guide 21,

Disclosure of Risk Factors, Guidelines for Form N–

1A [17 CFR 239.15A & 274.11A] (mutual funds);

Item 8.3.a., Form N–2 [17 CFR 239.14 & 274.11a1] (closed-end funds).

4See Form N–1A, Item 4(a)(ii) (requires concise

description of mutual fund investment objectives

and policies and brief discussion of how the fund

proposes to achieve such objectives, including

description of the securities in which the fund will

invest and special investment practices or

techniques that will be employed); Form N–1A,

Item 4(b) (requires discussion of types of

investments, policies, and practices that will not

constitute the ‘‘principal portfolio emphasis’’ of a

mutual fund, but which place more than 5% of the

fund’s net assets at risk); Form N–2, Item 8.2. & 8.4.

(similar requirements for closed-end funds).

5See Memorandum dated Sept. 26, 1994, from

Division of Investment Management to Chairman

Levitt regarding Mutual Funds and Derivative

Instruments 11 [hereinafter ‘‘Derivatives Report’’];

Letter to Registrants from Carolyn B. Lewis,

Assistant Director, Division of Investment

Management 7 (Feb. 25, 1994) (both documents on

file with the SEC’s Public Reference Room).

6According to a June 1994 survey sponsored by

the Investment Company Institute, 31% of United

States households owned shares in a mutual fund,

up from 6% of households in 1980. Investment

Company Institute, Fundamentals (Sept. 1994);

Investment Company Institute, 1994 Mutual Fund

Fact Book 85 (34th ed. 1994) [hereinafter ‘‘1994 ICI

Fact Book’’]. Mutual funds held 14.9% of all

household discretionary assets as of June 30, 1994,

up from 7.0% at the end of 1982. Source:

Investment Company Institute. Total mutual fund

assets have grown from $292.9 billion at the end of

1983 to $2.16 trillion at the end of December 1994.

1994 ICI Fact Book, supra, at 26; Investment

Company Institute Press Release, ‘‘December

Mutual Fund Sales Total $39.9 Billion,’’ Jan. 26,

1995, at 4.

By the end of 1993, retirement assets accounted

for 23% of mutual fund assets (excluding variable

annuities), and mutual funds held almost $284

billion of the approximately $857 billion invested

in individual retirement accounts (‘‘IRAs’’)—about

33% of total IRA assets. 1994 ICI Fact Book, supra,

at 69.

7See, e.g., Burton G. Malkiel, A Random Walk

Down Wall Street ch. 13 (1990) [hereinafter

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Parts 239, 270, and 274

[Release Nos. 33–7153; 34–35546; IC–

20974; File No. S7–10–95]

RIN 3235–AG43

Improving Descriptions of Risk by

Mutual Funds and Other Investment

Companies

AGENCY: Securities and Exchange

Commission.

ACTION: Concept release; request for

comments.

SUMMARY: The Securities and Exchange

Commission (the ‘‘SEC’’ or

‘‘Commission’’) is seeking comments

and suggestions on how to improve the

descriptions of risk provided to

investors by mutual funds and other

management investment companies

(‘‘funds’’ or ‘‘investment companies’’).

In order to encourage individual

investor comments and suggestions, the

SEC is including in the Release an

appendix directed to investors, which

the SEC intends to reprint separately

and distribute to investors.

DATES: The SEC requests comments on

or before July 7, 1995.

ADDRESSES: Three copies of your

comments should be submitted to

Jonathan G. Katz, Secretary, Securities

and Exchange Commission, 450 Fifth

Street NW., Washington, D.C. 20549. All

comment letters should refer to File No.

S7–10–95. All comments received will

be available for public inspection and

copying in the SEC’s Public Reference

Room, 450 Fifth Street NW.,

Washington, D.C. 20549. If you are an

individual investor and do not have

access to a copier machine, you may

send in one copy of your comments.

FOR FURTHER INFORMATION CONTACT:

Susan Nash, Senior Special Counsel,

(202) 942–0697, Paul B. Goldman, Chief

Financial Analyst, (202) 942–0510,

Roseanne Harford, Senior Counsel, (202)

942–0689, Martha H. Platt, Senior

Counsel, (202) 942–0725, in the

Division of Investment Management, or

Craig McCann, Professional Fellow,

(202) 942–8032, Office of Economic

Analysis.

SUPPLEMENTARY INFORMATION:

Executive Summary

Today the SEC is continuing its efforts

to enhance the information that

investors in funds receive to assist them

in making an informed investment

decision. In recent years, the SEC has

taken significant steps designed to

improve the understandability and

comparability of fund disclosure of

performance and expenses.1 The SEC is

now requesting comment on how to

improve risk disclosure for investment

companies, including ways to increase

the comparability of disclosure about

funds’ risk levels through quantitative

measures or other means.2

Under existing SEC rules, a fund is

required to discuss in its prospectus the

principal risk factors associated with

investing in the fund.3 Funds typically

describe the risks of investing in the

fund by describing the risks of

particular investment policies that the

fund may use and investments that the

fund may make.4 Lengthy and highly

technical descriptions of permissible

policies and investments that are often

used in meeting existing requirements

may make it difficult for investors to

understand the total risk level of a fund.

The SEC staff has found that funds

typically provide only the most general

information on the risk level of the fund

taken as a whole and has encouraged

funds to modify their existing disclosure

to enhance investor understanding of

risks.5 The SEC believes that it is now

appropriate to explore whether SEC

disclosure requirements should be

revised in order to improve the

communication of fund risks to

investors and increase the likelihood

that investors will readily grasp the

risks of investing in a particular fund

before they invest.

Several factors make it important that

the SEC explore better ways of

explaining fund risks to investors. First,

average Americans are placing

increasing reliance on funds to meet

important financial needs, such as

retirement and college expenses.6

Understanding the risks of various

investment products is one of the most

important ingredients in creating an

overall investment strategy or portfolio

to meet these financial needs.7 Second,
Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules 17173

‘‘Random Walk’’]; Susan E. Kuhn, ‘‘What it Takes

to Retire Today,’’ Fortune, Dec. 26, 1994, at 113;

Joshua Shapiro, ‘‘The Discipline of Saving for

College,’’ New York Times, Sept. 10, 1994, at 34.

8See Testimony of Arthur Levitt, Chairman, U.S.

Securities and Exchange Commission, Concerning

Issues Affecting the Mutual Fund Industry, Before

the Subcommittee on Telecommunications and

Finance, Committee on Energy and Commerce, U.S.

House of Representatives 18–19 (Sept. 27, 1994);

Derivatives Report, supra note 5, at 11–12.

9See, e.g., 1994 ICI Fact Book, supra note 6, at

30–31 (increase from 564 mutual funds at the end

of 1980 to 4,558 at the end of 1993; mutual funds

classified according to 21 investment objectives).

10See, e.g., Leslie Eaton, ‘‘Paine Webber to Bail

Out Fund Battered by Complex Investments,’’ New

York Times, July 23, 1994, at A1; Robert McGough,

‘‘Piper Jaffray Acts to Boost Battered Fund,’’ Wall

Street Journal, May 23, 1994, at C1.

11See, e.g., Karen Donovan, ‘‘Derivatives Slump;

Losers Go to Court,’’ National Law Journal, Nov. 7,

1994, at A1; G. Bruce Knecht, ‘‘Minneapolis

Investors Are Hurt By Local Firm They Knew As

Cautious,’’ Wall Street Journal, Aug. 26, 1994, at

A1; John Waggoner, ‘‘Mutual Fund Losses Anger

Novice Investors,’’ USA Today, June 16, 1994, at

1B.

12See Letter to Barry P. Barbash, Director,

Division of Investment Management, from Paul

Schott Stevens, General Counsel, Investment

Company Institute 3–4 (Jan. 19, 1995) [hereinafter

‘‘ICI Letter’’] (on file with the SEC’s Public

Reference Room) (discussing different concepts of

risk); Paul A. Samuelson, ‘‘The Long-Term Case for

Equities and How it Can be Oversold,’’ Journal of

Portfolio Management 15–24 (Fall 1994) (raising

questions about common wisdom that, for longterm investor, stocks will outperform bonds or

cash).

13See supra notes 10 and 11 and accompanying

text. A recent industry survey of non-money market

funds indicated that the level of derivatives use

varied by fund type, with fixed income funds

Continued

new ways of describing risks may

improve investor understanding of the

risks associated with the use by some

funds of increasingly complex

instruments, such as derivatives.8 Third,

the number and types of funds have

proliferated, increasing fund investors’

need for information that will help them

to compare and contrast alternatives.9

The importance of risk disclosure was

underscored last year when some shortterm government bond funds

experienced losses as interest rates

increased sharply.10 Shareholders in

these funds expressed surprise at the

losses, and several shareholder lawsuits

were filed.11 Whatever the legal merits

of the shareholder complaints may be,

the SEC believes that these events

highlight the importance of clear,

concise disclosure of risks.

In this Release, the SEC requests that

those submitting comments discuss the

specific goals of, and various

alternatives for, improving risk

disclosure. Comments are requested on

the relative merits of written and other

presentations of risk, including

quantitative or numerical measures,

graphs, tables, and other pictorial

representations.

The Release describes and requests

comment on several specific

quantitative measures of risk and riskadjusted performance, including

standard deviation, semi-variance, beta,

duration, the Sharpe Ratio, the Treynor

Ratio, and Jensen’s Alpha. These

measures of risk are potentially useful

because they may give investors a tool

for balancing the potential returns of a

fund against the risks of the fund. For

instance, if a fund has historical annual

returns which are 2% above a market

index, historical risk measures may

provide some indication of the risks that

were taken to produce the increased

returns. Quantitative risk measurements

may provide investors with tools to

measure how funds have fared

historically in the relationship between

risk and return.

The Release also asks for comments

addressing a number of general topics

related to quantitative risk measures.

These include:

• The benefits to be derived from

quantitative measures versus the costs

and burdens to the fund that must

produce such information;

• Quantitative measures currently

used by fund managers to assess risk,

and whether such internally used

measures should be disclosed to

investors;

• Investor understanding of

quantitative measures, and means to

increase that understanding;

• Standardizing the ways in which

funds calculate quantitative measures to

assure comparability and the validity of

any underlying assumptions; and

• Availability of quantitative risk

information from third party providers

(e.g., the financial press and rating

services).

Comments are also requested on

whether funds should be required to

disclose a self-assessment of their risk

level, using an SEC-created standard

scale or some other method. In addition,

comments are requested on whether

funds should describe to investors the

ways or strategies that fund managers

use to manage, understand, and monitor

the risks of their funds.

The SEC requests comments that

address the specific questions posed in

this Release as well as alternative risk

disclosure methods and related matters.

Where possible, please provide actual

rule language that you believe would

best express your recommendation.

To encourage individual investor

comments and suggestions on this

Release, the SEC for the first time has

prepared a short summary specifically

directed to individual investors. The

summary, which appears as an

appendix to the Release, will be

reprinted in a format that leaves space

for individual investors to tell the SEC

about their concerns and ideas and

distributed through investor groups and

other means designed to reach

individual investors.

I. The Goals of Risk Disclosure

The SEC’s goal is to improve

disclosure of fund risks so that investors

will have the information they need to

understand the risk of any particular

fund investment. The best means for

achieving this aim may depend, in part,

on the specific goals of risk disclosure.

The SEC therefore requests comment on

the specific goals of risk disclosure,

including the matters raised below.

The SEC asks persons submitting

comments to define, as precisely as

possible, what ‘‘risks’’ should be

disclosed to investors. To what extent

are investors concerned with the

likelihood that they will lose principal,

that their return will not exceed a

specified benchmark (such as the

Standard & Poor’s (‘‘S&P’’) 500), or with

the variability of their returns (or the

volatility of the value of their

investment) over time? How should the

relationship between risk and an

investor’s time horizon shape the

disclosure that is provided to investors?

For example, is the same risk

information useful to an investor with

an investment time horizon of less than

one year and to an investor with an

investment time horizon of twenty

years? 12 How can the disclosure of risk

help investors answer the fundamental

questions—Is this investment suitable

for me? If I have diversified my

investments, how does this particular

fund fit into my diversification strategy?

Comments are requested on the nature

of risk comparisons that are useful to

investors. For example, should risk

disclosure facilitate comparison among

a broad range of investment options,

such as between funds and other

investment products? Or is it sufficient

to facilitate comparisons among all

funds and fund types, both equity and

fixed income? Or among all equity

funds, on the one hand, and all fixed

income funds, on the other? Or only

within groups of funds with similar

investment objectives and policies, such

as short-term government bond funds?

Is improved disclosure of risks

equally important for equity, fixed

income, and balanced or asset allocation

funds? Do recent derivatives-related

losses by some fixed income funds, and

the apparently greater use of derivatives

by fixed income funds, suggest that the

need for improved disclosure of risks is

greater for fixed income funds? 13 In
17174 Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules

accounting for 84% of the total market value of all

derivatives held by reporting funds and 62% of the

total national amount. Investment Company

Institute, Derivative Securities Survey 6 (Feb. 1994).

Survey respondents included 52 fund complexes

with 1,728 non-money market funds holding

aggregate net assets of $958 billion (76% of industry

assets in non-money market funds). Id. at 4.

14Mutual funds are prohibited from calling

themselves money market funds unless they

comply with the risk-limiting provisions of rule 2a–

7 under the Investment Company Act. These

provisions are designed to limit a fund’s exposure

to credit, interest rate, and currency risks. 17 CFR

270.2a–7(b), (c)(2)–(4), & (d).

15Losses in the value of certain adjustable rate

notes held by some money market funds recently

resulted in the funds’ advisers electing to take

actions designed to prevent the funds’ per share net

asset values from falling below $1.00; and one

small, institutional money market fund liquidated

and redeemed its shares at less than $1.00 as a

result of such losses. See, e.g., ‘‘A History of

Stepping up to the Plate,’’ Fund Action, Sept. 12,

1994, at 9; Brett D. Fromson, ‘‘Losses on Derivatives

Lead Money Fund to Liquidate,’’ Washington Post,

Sept. 28, 1994, at F1. These losses, however, raise

concerns about the appropriateness of the funds’

investments in some types of adjustable rate

securities and not merely risk disclosure concerns.

See Revisions to Rules Regulating Money Market

Funds, Investment Company Act Rel. No. 19959,

§ II.D.2.d. (Dec. 17, 1993) [58 FR 68585, 68601–02

(Dec. 28, 1993)] [hereinafter ‘‘Rel. 19959’’] (certain

types of adjustable rate notes not appropriate

investments for money market funds). See also

Letter from Barry P. Barbash, Director, Division of

Investment Management, to Paul Schott Stevens,

General Counsel, Investment Company Institute

(June 30, 1994) (on file with the SEC’s Public

Reference Room).

16See Derivatives Report, supra note 5, at 11.

17See supra notes 3 and 4 and accompanying

text.

18For mutual funds, see Form N–1A, Items 2

(Synopsis), 3 (Condensed Financial Information),

and 5A (Management’s Discussion of Fund

Performance). For closed-end funds, see Form N–

2, Items 3 (Fee Table and Synopsis) and 4

(Financial Highlights). See also supra note 1 and

accompanying text. A closed-end fund is also

required to include in its prospectus a table

quantifying the effects of leverage on returns to

investors. Form N–2, Item 8.3.b.(3) (General

Description of the Registrant, Risk Factors, Effects

of Leverage).

19See supra note 1. The SEC also recently

adopted rules requiring graphic depictions of issuer

performance by public companies that are not

investment companies. Executive Compensation

Disclosure, Securities Exchange Act Rel. No. 31327

(Oct. 16, 1992) [57 FR 48126 (Oct. 21, 1992)].

20William F. Sharpe, Gordon J. Alexander, and

Jeffery V. Bailey, Investments 178 (5th ed. 1995)

light of the substantive limits on

permitted money market fund

investments,14 should risk disclosure

requirements for money market funds be

different from those applicable to other

funds? 15

Comments are also requested on the

degree of detail regarding fund risk that

ideally would be communicated to

investors. In meeting existing disclosure

requirements, funds often describe the

purposes of using particular types of

instruments and the risks associated

with each type, but typically provide

only the most general information on

the risk level of the fund taken as a

whole.16 Should disclosure convey the

risks of each particular type of

instrument held by a fund, the risks of

broader classes of instruments (for

instance, derivatives as a group), the

risks of the fund’s portfolio as a whole,

or some combination of the foregoing?

Should the focus of disclosure be

shifted from the characteristics of

particular securities to the nature of the

investment management services

offered, including the objectives of a

fund manager and the associated risks

and rewards? Do investors need to

understand separately the different

types of risk, such as market, credit,

legal, and operational risks, or is it the

aggregate effect of different types of risk

that is important to an investment

decision?

II. Narrative and Non-Narrative Risk

Disclosure Options

The SEC currently requires fund

prospectuses to include narrative

descriptions of risk,17 and the SEC is

interested in the potential for improving

risk disclosure through changes to the

narrative disclosure requirements and

the use of non-narrative forms of

disclosure. The SEC therefore asks

persons submitting comments to discuss

the contributions that both narrative and

non-narrative forms of disclosure can

make to investor understanding of risk

and to provide the SEC with the

findings of any relevant market research

on the effective communication of risk.

At present, a number of funds

voluntarily supplement narrative

descriptions of risk through means such

as quantitative measures, graphs, tables,

and other pictorial representations. For

example, some funds provide

quantitative risk measures like those

described in section III.A. of this

Release. Another method used is a line

graph that shows relative risk and return

levels for the fund and some

benchmark, such as Treasury bills or a

market index such as the S&P 500.

Another method is a bar graph that

shows consistency of returns for the

fund and a market index (as measured

by monthly rates of return over the life

of the fund). Finally, some fund families

use pictures to show the relative risks of

the various funds within the family.

The SEC believes that quantitative

measures, graphs, tables, and other

pictorial representations may assist

investors in understanding and

comparing funds. The SEC currently

requires disclosure of quantitative

information in tabular form in the areas

of fund performance and expenses.18

Recently, the SEC adopted rules that

require graphic depictions of

information to facilitate investor

understanding of fund performance.19

The SEC now requests comment on the

relative merits and usefulness of various

formats for investment company risk

disclosure, including quantitative

measures, graphs, tables, and other

pictorial representations. To what extent

should these methods be used to

supplement, or replace, current

narrative risk disclosure?

III. Quantitative Measures of Risk

A. Specific Historical Quantitative

Measures of Risk and Risk-Adjusted

Performance

This section of the Release discusses

several historical quantitative measures

of risk and risk-adjusted performance

that could be used for fund disclosure,

and the following section raises a

number of general questions about

quantitative measures. Comments are

requested regarding whether the SEC

should require fund disclosure of any

one or a combination of the enumerated

measures or any other measures.

Persons submitting comments are also

asked to consider each of the

enumerated quantitative measures, and

any other measures they may wish to

suggest, in the context of the general

questions raised in the following

section.

Historical measures of risk and riskadjusted performance are generally

calculated from past portfolio returns

and, in some cases, past market returns.

There are two broad classes of historical

risk measures, referred to in this Release

as total risk measures and market risk

measures. In addition, there is a third

class of measures, risk-adjusted

measures of performance. (Unless the

context indicates otherwise, riskadjusted measures of performance are

included in ‘‘quantitative risk

measures’’ and similar terms and

phrases used in this Release.) These

three classes of measures are described

below, and examples of each are

provided. Comments are requested on

the relative advantages and

disadvantages of the three classes of

measures and of specific measures

within each class.

1. Measures of Total Risk

Total risk measures, including

standard deviation and semi-variance,

quantify the total variability of a

portfolio’s returns around, or below, its

average return.

• Standard Deviation of Total Return.

The risk associated with a portfolio can

be viewed as the volatility of its returns,

measured by the standard deviation of

those returns.20 For example, a fund’s
Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules 17175

[hereinafter ‘‘Sharpe, Alexander, & Bailey’’]. If the

returns earned by a portfolio are ‘‘normally’’

distributed, that is, in the shape of a bell curve,

approximately 95% of the actual returns will fall

within two standard deviations of the average

return. Random Walk, supra note 7, at 219. For

example, for a fund with an average monthly return

of 1% and a standard deviation of 4%, 95% of the

fund’s monthly returns would fall between ¥7%

(1%¥(2×4%)) and 9% (1%+(2×4%)) if the returns

were ‘‘normally’’ distributed. See Sharpe,

Alexander, & Bailey, supra, at 177.

21See Sharpe, Alexander, & Bailey, supra note 20,

at 178; Allan Flader, ‘‘Deviating from the

Standard,’’ Financial Planning, June 1994, at 148.

22Funds’ risk levels would be ranked in the same

order using semi-variance and standard deviation if

the distribution of fund returns were symmetric.

Sharpe, Alexander, & Bailey, supra note 20, at 178.

23Zvi Bodie, Alex Kane, and Alan J. Marcus,

Investments 197 (2d ed. 1993) [hereinafter ‘‘Bodie,

Kane, & Marcus’’].

24Bodie, Kane, & Marcus, supra note 23, at 197–

99; Sharpe, Alexander, & Bailey, supra note 20, at

212–17.

25Sharpe, Alexander, & Bailey, supra note 20, at

211; Frank J. Fabozzi and Franco Modigliani,

Capital Markets: Institutions and Instruments 136–

40 (1992) [hereinafter ‘‘Fabozzi & Modigliani’’].

26The SEC previously requested comment on

duration as a measure of interest rate risk for

securities held by money market funds. See Rel.

19959, supra note 15, § II.D.2.d., 58 FR at 68602. In

response to that request, several persons submitting

comments expressed support for the use of duration

or other price volatility tests; one person

specifically opposed a duration requirement on the

grounds that the costs funds would incur would

outweigh benefits to investors. See Summary of

Comment Letters on Proposed Amendments to

Rules Regulating Money Market Funds Made in

Response to Investment Company Act Rel. 19959,

File No. S7–34–93, Nov. 10, 1994, at 63–64.

27Bodie, Kane, & Marcus, supra note 23, at 473–

74. Duration measures the weighted average

maturity of a bond’s, or bond portfolio’s, cash flows,

i.e., principal and interest payments. A zero-coupon

bond’s duration, for example, is the same as its

maturity because its sole cash flow is the payment

made at maturity. By contrast, a bond bearing

interest payable periodically has a duration that is

shorter than its maturity because the periodic

interest payments reduce the weighted average

maturity of the bond’s cash flows below the final

maturity of the bond. Id.

28For a discussion of the computation and

interpretation of so-called ‘‘Macaulay duration’’ and

‘‘modified duration,’’ see Bodie, Kane, & Marcus,

supra note 23, at 473–75, and Fabozzi & Modigliani,

supra note 25, at 393–98.

29Fabozzi & Modigliani, supra note 25, at 397.

For example, if a bond portfolio has a modified

duration of 7 and yield increases by 100 basis

points, the estimated decrease in the value of the

portfolio would be 7%.

30See James Hom and Gary Arne, Standard &

Poor’s, ‘‘Prepayments and Model Error in Fund Risk

Ratings,’’ CreditReview, Jan. 16, 1995, at 17–18;

John Rekenthaler, Commentary: ‘‘Duration Arrives,’’

Morningstar Mutual Funds, Jan. 21, 1994, at 1–2.

31 Duration is less useful as a measure of interest

rate risk when the following conditions are not met:

(1) the yield curve is flat (i.e., interest rates for all

maturities of bonds are the same), (2) changes in

yield are small, and (3) yield shifts are parallel (i.e.,

the Treasury yields of all maturities change by

equal numbers of basis points). See Fabozzi &

Modigliani, supra note 25, at 396–401.

32See, e.g., Form N–7 for Registration of Unit

Investment Trusts Under the Securities Act of 1933

and the Investment Company Act of 1940,

Investment Company Act Rel. No. 15612 (Mar. 9,

1987) [52 FR 8268, 8301 (Mar. 17, 1987)] (guide to

proposed registration form for unit investment

trusts publishing staff position on portfolio

maturity).

historical risk could be measured by

computing the standard deviation of its

monthly total returns over some prior

period, such as the past three years. The

larger the standard deviation of monthly

total returns, the more volatile, i.e.,

spread out around the fund’s average

monthly total return, the fund’s monthly

total returns have been over the prior

period. Standard deviation of total

return can be calculated for funds with

different objectives, ranging from equity

funds to fixed income funds to balanced

funds, and can be measured over

different time frames. For example, a

fund could calculate standard deviation

of monthly returns over the prior three

years or yearly returns over the prior ten

years.

• Semi-variance. Standard deviation

measures both ‘‘good’’ and ‘‘bad’’

outcomes, i.e., the variability of returns

both above and below the average

return. To the individual investor,

however, risk may be synonymous with

‘‘bad’’ outcomes.21 Semi-variance,

which can be used to measure the

variability of returns below the average

return, reflects this view of risk.22 A

fund with a larger semi-variance has

returns that are more spread out below

the average return.

2. Measures of Market Risk

Individual securities, and portfolios of

securities, are generally subject to two

sources of risk: (i) Risk attributable to

firm-specific factors, including research

and development, marketing, and

quality of management; and (ii) risk

attributable to general economic

conditions, including the inflation rate,

interest rates, and exchange rates.23

According to academic literature in

Finance, firm-specific risk can be

reduced or eliminated through portfolio

diversification, but the risk attributable

to general economic conditions, socalled ‘‘market risk,’’ cannot be

eliminated through diversification.24

Unlike standard deviation and variance,

which measure portfolio risk from both

sources, the measures described in this

section are measures of market risk. The

SEC requests comment on whether,

given that most fund portfolios are

diversified, it is appropriate to focus on

market risk when measuring fund risks.

• Beta. Beta measures the sensitivity

of a security’s, or portfolio’s, return to

the market’s return. The market’s beta is

by definition equal to 1. Portfolios with

betas greater than 1 are more volatile

than the market, and portfolios with

betas less than 1 are less volatile than

the market. For example, if a portfolio

has a beta of 2, a 10% market return

would result in a 20% portfolio return,

and a 10% market loss would result in

a 20% portfolio loss (excluding the

effects of any firm-specific risk that has

not been eliminated through

diversification).25

The calculation of a fund’s historical

beta requires the selection of a

benchmark market index, and persons

supporting the use of beta are asked to

address how the benchmark should be

selected and whether a single

benchmark should be used for all funds.

If a single benchmark should be

selected, what should it be? If a single

benchmark is not used, how should the

lack of comparability of betas for funds

using different benchmarks be

addressed? Beta is generally used in

connection with equity securities, and

persons submitting comments are asked

to address whether or not the use of beta

should be limited to equity funds.

• Duration.26 Duration is a measure of

the price sensitivity of a bond, or bond

portfolio, to interest rate changes.27

There are different types of duration,28

and persons supporting the use of

duration are asked to be specific

regarding the duration measure that

they support. Would so-called

‘‘modified duration,’’ which can be

interpreted as the percentage change in

the price of a bond, or bond portfolio,

for a 100 basis point change in yield, be

particularly useful? 29

The use of duration has several

limitations, and persons submitting

comments are asked to address each of

these. First, duration is only meaningful

for bonds and portfolios of bonds and

therefore cannot be used to measure the

risk of equity funds and has limited

applicability to balanced funds. Second,

duration measures interest rate risk only

and not other risks to which bonds are

subject, e.g., credit risks and, in the case

of non-dollar denominated bonds,

currency risks. Third, duration is

difficult to calculate precisely for bonds

with prepayment options, e.g.,

mortgage-backed securities, because the

calculation requires assumptions about

prepayment rates.30 Fourth, bond value

changes resulting from interest rate

changes are sometimes poorly predicted

by duration.31

The SEC staff takes the position that,

for a fund with a name or investment

objective that refers to the maturity of

the fund’s portfolio, such as ‘‘shortterm’’ or ‘‘long-term,’’ the dollarweighted average portfolio maturity of

the portfolio must reflect that

characterization.32 The SEC requests
17176 Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules

33The SEC has solicited comment on riskadjusted measures of performance on two prior

occasions. In 1990, the SEC requested comment on

whether mutual funds should be required to adjust

performance figures to reflect risk for purposes of

Item 5A of Form N–1A. See Disclosure and

Analysis of Mutual Fund Performance Information;

Portfolio Manager Disclosure, Investment Company

Act Rel. No. 17294 (Jan. 8, 1990) [55 FR 1460, 1464

(Jan. 16, 1990)]. See also Summary of Comments on

Proposed Amendments to Form N–1A, File S7–1–

90, at 23–24 (summarizing views of the nine

persons submitting comments who addressed risk

adjustment of performance, all of whom opposed

it).

In 1986, the SEC requested comment on how

mutual funds could present risk-adjusted

performance information in advertisements

prepared in accordance with rule 482 under the

Securities Act of 1933 [17 CFR 230.482]. See

Advertising by Investment Companies; Proposed

Rules and Amendments to Rules, Forms, and

Guidelines, Investment Company Act Rel. No.

15315 (Sept. 17, 1986) [51 FR 34384, 34390 (Sept.

26, 1986)]. See also Summary of Comments on

Mutual Fund Advertising Proposals, File No. S7–

23–86, Mar. 31, 1987, at 69–70 (summarizing views

of the thirteen persons submitting comments who

addressed the issue, including nine who supported

it and one who opposed it).

34See William F. Sharpe, ‘‘The Sharpe Ratio,’’ 21

Journal of Portfolio Management 49–58 (Fall 1994);

William F. Sharpe, ‘‘Mutual Fund Performance,’’ 39

Journal of Business 119–38 (Jan. 1966); Sharpe,

Alexander, & Bailey, supra note 20, at 935–37;

Edwin J. Elton & Martin J. Gruber, Modern Portfolio

Theory and Investment Analysis 648–52 (4th ed.

1991) [hereinafter ‘‘Elton & Gruber’’].

35The yield on 90-day Treasury bills is often used

as a proxy for the risk-free rate of return.

36See Jack L. Treynor, ‘‘How to Rate Management

of Investment Funds,’’ 43 Harvard Business Review

63–75 (Jan.-Feb. 1965); Sharpe, Alexander, & Bailey,

supra note 20, at 934–35; Elton & Gruber, supra

note 34, at 657–58.

37Michael C. Jensen, ‘‘The Performance of Mutual

Funds in the Period 1945–1964,’’ 23 Journal of

Finance 389–416 (May 1968); Michael C. Jensen,

‘‘Risk, the Pricing of Capital Assets, and the

Evaluation of Investment Portfolios,’’ Journal of

Business (Apr. 1969); Sharpe, Alexander, & Bailey,

supra note 20, at 927–34.

38For an equity fund, the benchmark portfolio

could be comprised of a market index, e.g., the S&P

500, and a risk-free asset, e.g., 90-day Treasury bills.

Sharpe, Alexander, & Bailey, supra note 20, at 798.

39Form N–1A, Item 3; Form N–2, Item 4.

40For discussions of the importance of risk as a

component of performance evaluation, see Sharpe,

Alexander, & Bailey, supra note 20, at 917–49, and

Bodie, Kane, & Marcus, supra note 23, at 796–826.

Funds are currently required to disclose historical

returns for each of the last ten fiscal years (or, if

less, the life of the fund). See Form N–1A, Item 3.

This data shows variability of past annual returns

and therefore provides some guidance regarding

past risk.

41See Form N–1A, Item 3; Form N–2, Item 4

(financial highlights table).

42See Form N–1A, Item 3 & Form N–2, Item 4

(fund financial highlights tables cover each of last

ten fiscal years); rule 34b–1 under the Investment

Company Act [17 CFR 270.34b–1] & rule 482(e)(3)

under the Securities Act [17 CFR 230.482(e)(3)]

(non-money market mutual fund advertisements

and sales literature containing performance

information required to contain average annual total

return for one, five, and ten years).

comment on whether, separate and

apart from duration’s potential use as a

quantitative risk measure, a fund’s name

or investment objective that refers to the

maturity of its portfolio should be

required to be consistent with the fund’s

duration.

3. Risk-Adjusted Measures of

Performance 33

Risk-adjusted measures of

performance were developed in the

1960s to compare the quality of

investment management. Three widelyused risk-adjusted measures are:

• Sharpe Ratio.34 Also known as the

Reward-to-Variability Ratio, this is the

ratio of a fund’s average return in excess

of the risk-free rate of return (‘‘average

excess return’’) 35 to the standard

deviation of the fund’s excess returns. It

measures the returns earned in excess of

those that could have been earned on a

riskless investment per unit of total risk

assumed.

• Treynor Ratio.36 Also known as the

Reward-to-Volatility Ratio, this is the

ratio of a fund’s average excess return to

the fund’s beta. It measures the returns

earned in excess of those that could

have been earned on a riskless

investment per unit of market risk

assumed. Unlike the Sharpe Ratio, the

Treynor Ratio uses market risk (beta),

rather than total risk (standard

deviation), as the measure of risk.

• Jensen’s Alpha.37 This is the

difference between a fund’s actual

returns and those that could have been

earned on a benchmark portfolio with

the same amount of market risk, i.e., the

same beta, as the portfolio.38 Jensen’s

Alpha measures the ability of active

management to increase returns above

those that are purely a reward for

bearing market risk.

B. General Issues

This section of the Release raises a

number of general questions about

quantitative risk measures. Persons

submitting comments are asked to

address these questions, particularly in

the context of specific quantitative

measures.

1. Benefits of Quantitative Risk

Measures

The SEC asks for comments on the

potential benefits that could be derived

from fund disclosure of quantitative risk

measures. Comments are also requested

on associated costs and burdens.

Would quantitative risk measures,

including risk-adjusted measures of

performance, help investors to evaluate

historical performance and investment

management expertise? The SEC

requires that fund prospectuses include

standardized return information,39 even

though past returns are not necessarily

indicative of future returns. Persons

submitting comments are asked to

address whether quantitative disclosure

of the risk level incurred to produce

stated returns may provide investors

with a better tool to understand past

fund performance and management.40

Historical data could, for example, help

investors distinguish among funds that

have achieved comparable rates of

return with significantly different levels

of risk. Would it be helpful to investors

for funds to present one or more risk

measures together with fund

performance data in the financial

highlights table? 41 Would a risk

measure that covers the same periods

currently required for reporting total

returns in the financial highlights table

in fund prospectuses or in mutual fund

advertisements be useful to investors? 42

Would quantitative risk measures be

useful to investors as indicators or

guides to future fund risk levels,

enhancing investors’ ability to compare

risks assumed by investing in different

funds? The SEC requests any research

related to the degree of correlation

between historical measures of a fund’s

risk and expected future levels of risk.

2. Risk Measures Currently Used by

Investment Companies

The SEC requests comment on

whether quantitative risk measures that

are currently used by investment

companies for internal purposes, such

as portfolio management, evaluation or

compensation of portfolio managers,

and reports by management to the board

of directors, could be adapted for

disclosure purposes. This approach

could have two potential advantages:

first, the measures currently used by

investment companies presumably have

been determined to be the most useful

by fund managers, who are in the best

position to understand and analyze fund

risk; and, second, use of these measures

for disclosure purposes should impose

relatively small additional costs on

funds. The SEC therefore requests that

persons submitting comments identify

which quantitative risk measures funds

use internally and for what purposes.

The SEC also asks persons submitting

comments to discuss the extent to

which quantitative risk measures used

by investment companies for internal

purposes would be useful to investors.

If such measures would not be useful to

investors, why not? How might internal

measures be adapted to avoid or

overcome these problems?

3. Investor Understanding of

Quantitative Risk Measures

Persons submitting comments are

asked to discuss the difficulties that
Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules 17177

43See, e.g., Comptroller of the Currency, Risk

Management of Financial Derivatives 49–53 (Oct.

1994); J.P. Morgan, Introduction to RiskMetricsTM

(2d ed.) (Oct. 25, 1994); Group of Thirty,

Derivatives: Practices and Principles 10–11 (July

1993).

44The Investment Company Institute has

suggested that portfolio-based measures would be of

limited relevance at best in an actively managed

portfolio, would ignore the role of portfolio

management, and would be burdensome to

compute. ICI Letter, supra note 12, at 8 n.10.

45 Issues have arisen with respect to fund

advertisement of performance information in

similar circumstances. See IDS Financial Corp.

(pub. avail. Dec. 19, 1994) (acquisition of other

funds’ assets); North American Security Trust (pub.

avail. Aug. 5, 1994) (combination of two funds); The

Managers Core Trust (pub. avail. Jan. 28, 1993)

(newly formed hub fund); Unified Funds (pub.

avail. Apr. 23, 1991) (changed investment adviser);

John Hancock Asset Allocation Trust (pub. avail.

Jan. 3, 1991) (change from money market fund to

asset allocation fund); Founders Funds, Inc. (pub.

avail. Oct. 15, 1990) (change from unit investment

trust to mutual fund); Zweig Series Trust (pub.

avail. Jan. 10, 1990) (changed investment adviser);

Philadelphia Fund, Inc. (pub. avail. Oct. 17, 1989)

(changed investment adviser); Commonwealth

Funds (pub. avail. June 14, 1989) (combination of

two funds); Investment Trust of Boston Funds (pub.

avail. Apr. 13, 1989) (changed investment adviser);

The Fairmont Fund Trust (pub. avail. Dec. 9, 1988)

(changed investment objective); and Growth Stock

Outlook Trust, Inc. (pub. avail. Apr. 15, 1986) (new

fund).

investors would face in properly

interpreting various quantitative risk

measures, such as understanding what

aspects of risk are measured, the limits

on predictive utility of risk measures,

and the importance of investment time

horizon in determining how much risk

to assume. Are the difficulties

significantly greater than those

associated with the proper

interpretation of yield and return

figures? Is there a potential problem of

investor over-reliance on quantitative

risk measures, and, if so, what could be

done to protect against such overreliance?

Comments are also requested

regarding which quantitative risk

measures would be easiest for investors

to use properly and how quantitative

measures can be made more

understandable to investors. One

possibility is to provide some form of

interpretation of raw numbers. For

example, standard deviations could be

divided by the standard deviation for

some benchmark such as the S&P 500.

Another possibility is to convert raw

numbers into a classification scale, such

as one to ten or ‘‘very low’’ to ‘‘very

high’’ risk. Another possibility would be

to represent the level of fund volatility

graphically, rather than through

computation of standard deviation.

Would it be helpful, for example, if

funds were required to include a bar

graph showing total returns for each of

the last 10 years to provide investors a

picture of the extent to which annual

returns varied over that period and the

frequency with which the returns were

negative or below some benchmark?

Would a chart like the following be

helpful?

Using historical numbers, the

following illustrates the fund’s

estimated variability of quarterly returns

over the noted periods (i.e.,

approximately 95% of the time, the

fund’s quarterly returns fell within these

ranges).

10 year 5-year 3-year

¥5% to 9% ¥4% to 8% ¥5% to 8%.

Are there narrative disclosures that

can help investors to understand risk

measures? Persons submitting

comments are asked to report the results

of any experience with, or research on,

the relative effectiveness of alternative

means of presenting quantitative

information.

4. Historical Measures v. Portfolio-Based

Measures v. Risk Objectives or Targets

There are three approaches to the use

of quantitative risk measures: historical,

portfolio-based, and risk objectives or

targets. The SEC asks for comments on

the relative merits and limitations of

these three approaches.

The simple historical approach to

quantitative risk measures is outlined in

section III.A., above. This method

generally uses actual past returns of a

fund to compute a measure of risk for

the fund. An alternative is a portfoliobased computation, which calculates a

portfolio risk measure based on the

particular securities in the portfolio as

of a specified measurement date.43 This

method, too, is historical in that the

computation (i) uses the portfolio

composition as of a specified

measurement date, and (ii) the

computation is based on historical

behavior of the securities in the

portfolio.

There are at least two important

limitations of using portfolio-based

measures for fund disclosure: first, a

fund may be invested in newly

introduced financial instruments that

have little or no history, and for which

historical behavior must be estimated,

and, second, portfolio-based measures,

which are derived from portfolio

composition on one particular date, may

be less representative of the risk of a

managed portfolio over time than a

simple historical measure derived from

fund returns over a period of time.

The SEC seeks comment on whether

the SEC should require funds generally

to disclose portfolio-based risk

measures.44 The SEC also asks for

comments on whether such measures

could be useful for new funds that do

not have sufficient operating history to

make use of a simple historical measure

meaningful, funds that change their

investment objectives or policies, funds

that change investment advisers or

portfolio managers, or merged funds

comprised of different funds with

different operating histories and

different past risk levels.45

Another approach to risk measures is

requiring funds to announce risk

objectives or targets. Any of the risk and

risk-adjusted performance measures

could be used by funds in this manner.

For example, a fund could announce its

intention to follow a strategy that would

yield a standard deviation of 10%–12%

per year, a beta of 1.50–1.75 with

respect to the S&P 500, or a duration of

7–9 years. Comments are requested

regarding the relative merits of this

approach as compared to the simple

historical and portfolio-based

approaches. Persons submitting

comments are asked to address

specifically the relative merits for funds

with significant operating histories, new

funds, funds that change their

investment objectives or policies, funds

that change investment advisers or

portfolio managers, or merged funds

comprised of different funds with

different operating histories and

different past risk levels. Persons

supporting the use of simple historical

measures by relatively new funds, funds

that change their investment objectives

or policies or their investment advisers

or portfolio managers, or merged funds

are also asked to address whether

narrative disclosure should be required

to explain the limits on the usefulness

of the disclosure resulting from the

funds’ circumstances.

5. Computation Issues

Comments are requested on the

following issues related to computation

of quantitative risk measures and on any

other relevant computation issues. What

length of fund operating history is

required to make particular historical

risk measures useful? What

requirements should be imposed on

funds without this operating history?

For example, if 18 months of operations

are required to calculate a meaningful

standard deviation figure, should funds

that have been operating for less than 18

months be required to disclose the

standard deviation of an appropriate

market index or peer group of funds and

explain any differences they expect

between the fund’s standard deviation

and that of the index or peer group?
17178 Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules

46See, e.g., CDA/Wiesenberger, Mutual Funds

Update, Dec. 31, 1994; Morningstar Mutual Funds,

Dec. 9, 1994; The Value Line Mutual Fund Survey,

Part 2, Ratings & Reports, Feb. 21, 1995. Value Line

also ranks mutual funds in five risk categories,

based on historical standard deviation. How to Use

The Value Line Mutual Fund Survey, A

Subscriber’s Guide (1994), at 4–5.

47See, e.g., Business Week, Feb. 14, 1994, at 78–

79; Forbes, Aug. 29, 1994, at 174; CDA/

Wiesenberger, Investment Companies Yearbook

1994 441 (1994); Morningstar Mutual Fund

Performance Report, Jan. 1995, at 3; How to Use

The Value Line Mutual Fund Survey, A

Subscriber’s Guide (1994), at 4–5.

48These ratings are based on an analysis of factors

such as currency, interest rate, liquidity, and

mortgage prepayment risks; hedging; leverage; and

the use of derivatives. See ‘‘Bond Fund Risks

Revealed,’’ Fitch Research Special Report, Oct. 17,

1994, at 1; Gary Arne, Standard & Poor’s,

CreditReview, Jan. 16, 1995, at 12.

49 Investment Company Act § 30(b) [15 U.S.C.

80a–29(b)].

50Nationally Recognized Statistical Rating

Organizations, Securities Act Rel. No. 7085 (Aug.

31, 1994) [59 FR 46314 (Sept. 7, 1994)]. The SEC

is currently studying the comment letters received.

51See discussion supra notes 3–5 and

accompanying text.

52Mutual funds generally offer their shares on a

continuous basis and, as a result, are required to file

periodic ‘‘post-effective’’ amendments to their

registration statements in order to maintain a

‘‘current’’ prospectus required by section 10(a)(3) of

the Securities Act [15 U.S.C. 77j(a)(3)]. Posteffective amendments also satisfy the requirement

that mutual funds amend their Investment

Company Act registration statements annually [17

CFR 270.8b–16]. Because closed-end funds do not

generally offer their shares to the public on a

For risk measures that require the use

of a benchmark market index, what

issues, if any, are associated with the

selection of an appropriate benchmark?

How should the SEC address the need

to use assumptions to calculate certain

risk measures, such as the prepayment

assumptions that may be required to

calculate duration? Can various

quantitative risk measures be

manipulated and how do the various

measures differ in their susceptibility to

manipulation? How can the potential for

such manipulation be reduced or

eliminated? For instance, is there some

combination of risk measures the SEC

could require that would not be

susceptible to simultaneous

manipulation?

Persons submitting comments are also

asked to describe as specifically as

possible the computation method they

would recommend for any quantitative

risk measure they favor. For example,

persons favoring standard deviation

should specify whether monthly

returns, quarterly returns, or returns

over some other periods should be used.

As another example, persons favoring

beta should describe the benchmark or

benchmarks that should be used.

Persons submitting comments are also

asked to discuss the benefits and

limitations associated with their

recommended method of computation.

6. Effects on Portfolio Management

The SEC recognizes that requiring

disclosure of a quantitative risk measure

may affect portfolio management, e.g.,

causing fund managers to adopt more

conservative investment strategies.

Comments are requested regarding

whether, and how, disclosure of a

quantitative risk measure might

influence portfolio management and

evaluating the associated benefits and

detriments.

7. Third Party Providers of Quantitative

Risk Information

The financial press and other third

parties currently disseminate some

quantitative information regarding fund

risks. The available information

includes measures such as those

described in section III.A., including

standard deviation, beta, and duration.46

In addition, some organizations

disseminate fund performance ratings

that take risk into account 47 or fund risk

ratings.48 This data is made available

either through reports and other

documents published by the

organizations that collect and calculate

the measures or through periodicals and

newspapers covering financial issues.

The SEC asks persons submitting

comments to address the SEC’s role

with respect to disclosure of

quantitative risk information in light of

the availability of fund risk information

from the financial press and other third

parties. Is there, for example, helpful

risk information that third party

providers do not make available? Would

SEC-required disclosure be important to

ensure that all investors have access to

some quantitative risk information and

to help educate investors about the

importance of such information? Would

SEC-required disclosure be important to

facilitate comparability among funds by

ensuring that standardized quantitative

risk information will be available for all

funds? Would SEC-required disclosure

of a quantitative risk measure be helpful

wherever historic returns are reported to

indicate to investors the risks incurred

to generate those returns?

Persons submitting comments are also

asked to address whether the SEC

should take any steps to facilitate the

provision of fund risk information by

the financial press and other third

parties. For example, should the SEC

require more frequent disclosure of fund

portfolio holdings or more detailed

descriptions of fund portfolio holdings

to facilitate third party risk analyses? If

so, what information should the SEC

require funds to make available and

with what frequency? The SEC is

currently authorized to require funds to

file with the SEC ‘‘such information

* * * as the SEC may require, on a

semi-annual or quarterly basis, to keep

reasonably current the information and

documents contained in the [funds’

Investment Company Act of 1940]

registration statement[s] * * *.’’ 49

Persons submitting comments are asked

to address whether statutory

amendments would be required to

implement any recommendations they

make in response to this paragraph.

Last year, the SEC requested comment

regarding whether it should encourage

or require disclosure of third party fund

risk ratings in prospectuses, sales

literature, and advertisements.50 Persons

who wish to address that issue in the

context of today’s broad inquiry into

improved risk disclosure are invited to

do so.

IV. Narrative Disclosure Options

The SEC asks for comment on the

usefulness to investors of narrative risk

disclosure currently found in

prospectuses.51 The SEC also asks

persons submitting comments to

describe ways of improving narrative

risk disclosure that will not increase,

and may reduce, technical information

that may be of limited utility to

investors. For example, should

prospectus disclosure focus on the

broad investment strategies of a fund

rather than the particular investments

used to implement the strategy?

Can disclosure of fund risks be

improved through increased focus on

the policies and investments actually

used by a fund as opposed to all

permissible policies and investments?

For example, should a fund describe the

policies and investments that have been

used during some prior period, such as

the preceding year, or that the fund

intends to use during some future

period, such as the following year, and

simply list the other permitted policies

and investments? Or should funds be

required to provide a table or grid that

indicates whether, and the extent to

which, the policies and investments

authorized to be used were used during

some prior period, such as the

preceding year? If a fund intends to alter

the mix of policies and investments,

should it be required to describe the

projected change? In addressing the

questions of this paragraph, persons

submitting comments should consider

the possibilities of placing various

information in the prospectus,52 annual
Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules 17179

continuous basis, they generally do not update their

prospectuses periodically.

53Cf. Form N–1A, Item 4(b)(ii) (greater prospectus

disclosure required for investment practices that

place more than 5% of a fund’s net assets at risk).

54Form N–1A, Item 5A.

55 In Rel. 19342, supra note 2, the SEC requested

comment on this approach and other formats for

disclosing risk, including numerical scales and

other visual or symbolic representations. A limited

number of persons submitting comments addressed

these specific methods for standardizing risk

disclosure. Summary of Comments: Rel. 19342,

supra, note 2, at 17–18.

56 Investment Company Act rule 0–10 [17 CFR

270.0–10].

report, and statement of additional

information. For example, should the

prospectus focus on the policies and

investments the fund has actually made

and that it may make in the reasonably

foreseeable future, with the complete

list of permissible investments and

policies to be disclosed in the statement

of additional information? As another

example, should periodic reports be

enhanced to include more information

about what policies and investments the

fund has, in fact, pursued and what

risks were actually taken?

Can risks be accurately depicted

through narrative disclosure apart from

technical descriptions of particular

types of investments? Would investors

find it useful for funds to provide in

their prospectuses a summary of the risk

characteristics of the portfolio as a

whole either in lieu of or in addition to

disclosure of the characteristics of

particular types of permissible

investments? If a risk summary would

be useful, what risks should it address?

For example, should the SEC require a

fund that invests a specified level, e.g.,

5% or 10% or 25%, of its net assets in

a particular manner, e.g., securities of

non-U.S. companies, to discuss the

related risks, e.g., exchange rate

fluctuations? 53

A mutual fund’s Management’s

Discussion of Fund Performance

(‘‘Management’s Discussion’’),

contained in the prospectus or annual

report, is currently required to discuss

the factors, including the market

conditions and the investment

techniques and strategies, that

materially affected the fund’s

performance during the previous fiscal

year.54 The SEC requests comments

regarding whether narrative risk

disclosure can be improved through

amendments to the requirements for the

Management’s Discussion. Should the

SEC, for example, explicitly require the

Management’s Discussion to address the

risks assumed during the previous fiscal

year and the effects of those risks on

fund performance? Should the

requirement for the Management’s

Discussion be extended to money

market funds? If the Management’s

Discussion is a useful vehicle for risk

disclosure, how should disclosure be

accomplished for closed-end funds,

which are not subject to the

Management’s Discussion requirements?

V. Self-Assessment of Risk

Another alternative upon which the

SEC seeks comment is self-assessment

by funds of their aggregate risk level.

One approach might be to describe

where the fund fits on a risk scale from

low risk, for instance, a money market

fund, to moderate risk, for instance, a

growth and income fund investing in

S&P 500 stocks and high quality bonds,

to high risk, for instance, an emerging

market fund.55 Some fund complexes

currently place various funds within the

complex on a risk scale, and the SEC

requests comment on whether such an

approach would be useful for comparing

funds from different complexes. If risk

self-assessment is used, should the SEC

create a standard scale? Persons

supporting an SEC-created scale are

asked to describe specifically what that

scale should be, with particular

attention to designing the scale to

promote a high degree of uniformity in

funds’ self-assessments. Persons who

favor a self-assessment approach but not

an SEC-created scale are asked to

address how the approach will foster

meaningful investor comparisons among

funds.

Comments are also requested on

whether funds should be required to

provide self-assessments of their

exposures to various types of risk, with

the results presented in chart or table

format. Bond funds, for example, might

rate their interest rate risk, credit risk,

prepayment risk, and currency risk on a

scale of low to medium to high.

VI. Risk Management Procedures

The disclosure options described in

this Release have focused on improved

disclosure of the level of risk incurred

by a fund. Persons submitting comments

are also asked to consider whether

disclosure of fund risk management

procedures should be required. Such

disclosure could be narrative. For

example, should funds be required to

disclose the extent and nature of

involvement by the board of directors in

the risk management process? As

another example, should funds describe

the ‘‘stress-testing’’ they do to determine

how the portfolio will behave in various

market conditions? Alternately, such

disclosure could be quantitative in

format. For example, if the SEC requires

disclosure of a quantitative risk

objective or target, funds could be

required to disclose the funds’ actual

risk level in subsequent periods and

compare it with the previously-provided

objective or target and explain the

reasons for divergence.

VII. Liability Issues

Persons submitting comments are

asked to address the appropriate scope

of, and limits on, the liability of funds,

investment advisers, and others for

various risk disclosures. Persons

submitting comments should specify

any forms of risk disclosure that they

believe raise particularly significant

liability concerns, explain the concerns,

and suggest means for mitigating the

concerns.

VIII. Regulatory Flexibility Act

According to the SEC’s rules and

unless otherwise defined for a particular

rulemaking proceeding, an investment

company with net assets of $50 million

or less at the end of its most recent fiscal

year is a ‘‘small entity’’ for purposes of

the Regulatory Flexibility Act.56 The

SEC requests persons submitting

comments to describe and project fund

costs to provide the various disclosures

described in this Release, and any other

disclosure that persons submitting

comments may wish to discuss, and

address whether requiring the

disclosure would have a significant

economic impact on small entities. If so,

the SEC asks persons submitting

comments to describe that impact

specifically. Persons submitting

comments also are asked to suggest

methods for improving disclosure of

fund risks without imposing significant

costs on funds, specifically without

having a significant economic impact on

funds that are small entities.

IX. Conclusion

The SEC is seeking comments and

suggestions on a number of specific

issues related to fund disclosure of

risks. Persons submitting comments are

encouraged, however, to address any

other matters that they believe merit

examination.

Dated: March 29, 1995.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

Appendix—SEC Request for Investor

Suggestions on How To Improve the

Descriptions of Risk in Mutual Funds

The U.S. Securities and Exchange

Commission (‘‘the SEC’’), the federal

government agency that oversees mutual

funds, wants to hear from investors on
17180 Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules

how the descriptions of risk in mutual

funds may be improved. When investors

choose a mutual fund, they should

understand the risks of the fund before

they invest and not be surprised if the

value of their investment rises and falls

significantly.

The risks and potential rewards of

investing in any mutual fund are

explained in a written document

provided by the mutual fund called a

‘‘prospectus.’’ The prospectus contains

information that is important to making

an informed decision when choosing a

mutual fund.

The SEC is concerned that the

descriptions of risk in mutual fund

prospectuses are not as helpful or as

clear as they could be. The SEC is

seeking ideas and suggestions on how

these descriptions of risk may be

improved. Your ideas and suggestions

may shape how risks are explained in

the future and help investors make

better investment choices.

Here are a series of questions and

examples on how the descriptions of

risk may be improved. We urge you to

respond, whether you answer one

question or all, or just have general

comments. Feel free to use this form or

write a separate letter marked ‘‘File No.

S7–10–95.’’

Please mail your comments to the SEC

no later than July 7, 1995. Directions for

sending your comments to the SEC are

provided at the end of this document.

The SEC will make your comments and

other comments received by the SEC

available to the public.

How do you learn about mutual fund

risks? The SEC would like to know how

you learn about the risks of a mutual

fund before you invest in the fund.

• Do you learn about mutual fund

risks from the fund prospectus, a broker

or bank representative, an investment

adviser, a family member or friend,

magazines, newspapers, or other

publications? If you use more than one

of these sources, please list all of the

sources that you use.

• What information do you find most

useful in evaluating mutual fund risks?

What can the SEC do to provide

information about the risks of investing

in mutual funds that other sources of

information do not do?

How well do mutual fund

prospectuses describe the risks of

investing? The SEC would like to know

if you find the way mutual fund

prospectuses describe the risks of

investing to be helpful.

• Do mutual fund prospectuses give

you a good idea of the risks of investing?

What do you like about the way mutual

funds describe risk in their prospectuses

and what would you like funds to do

differently?

• Would you like all mutual fund

prospectuses to contain a summary of

the risks of investing in the fund? If so,

what would you like to see in the

summary?

• Provide copies of any mutual fund

descriptions of risk that you believe are

very helpful or unhelpful. Tell the SEC

what you like or don’t like about the

descriptions.

What do you want to know about

risk? Risk means different things to

different people. The SEC would like to

know how you define risk.

• Do you define risk as:

(1) the chance that you will lose part

of your investment;

(2) the chance that your investment

will earn less than a certain amount, for

example, a fixed percentage, such as 5%

per year, or the return on a no-risk

investment, such as a bank CD or U.S.

treasury bill, or the return on a stock or

bond index, such as the Standard &

Poor’s 500 stock index; or

(3) the variability in your fund’s

return, that is, the month-to-month or

year-to-year ups and downs in your

fund’s share price or its distributions?

Or do you define risk in some other

way?

• In choosing a mutual fund, are you

most interested in comparing the risks

of investing in the fund to the risks of

putting your money in:

(1) investments that are not mutual

funds, for example, bank CDs or

individual stocks and bonds;

(2) other mutual funds of all types;

(3) mutual funds of the same broad

type, for example, stock funds or bond

funds; or

(4) mutual funds with the same

investment objective, for example,

short-term bond funds?

• Is your need for information about

the risks of investing in mutual funds

greater for stock funds or bond funds, or

is your need for information about risk

the same in both cases? Explain.

Would you like risk to be described

with numbers, graphs, or tables? The

SEC is looking at a variety of ways that

mutual funds could tell investors about

risk in addition to, or instead of,

descriptions in words. The SEC would

like your ideas and suggestions about

which of those ways would be most

helpful to you.

• Do you find information most

helpful when it is in the form of written

descriptions, numbers, graphs, tables,

charts, pictures, or some other form?

Mutual funds today are required to

provide investors with their annual

returns for each of the past 10 years. By

looking at these returns, investors can

get an idea of how variable a fund’s

returns have been. This variability could

be illustrated with a bar graph like the

following.

BILLING CODE 8010–01–M
Federal Register / Vol. 60, No. 64 / Tuesday, April 4, 1995 / Proposed Rules 17181

BILLING CODE 8010–01–C

• Would you find a bar graph like the

above helpful in understanding the ups

and downs in a mutual fund’s annual

returns? Would it increase your

understanding of a fund’s risk if the

fund also provided you a bar graph of

the returns of a market index, such as

the Standard & Poor’s 500 stock index?

The SEC is looking at the possibility

of requiring mutual funds to use

numbers to tell investors about the risks

of investing. Examples of the numbers

that the SEC is considering as required

risk measures are:

• Standard Deviation of Total Return.

This number measures how variable a

fund’s total returns have been, that is,

how much they have gone up and

down. The larger the standard

deviation, the more variable a fund’s

total returns have been.

• Duration. This number measures

how sensitive a bond fund’s value is to

changes in interest rates.

If you have ideas about what risk

measurement numbers the SEC should

ask mutual funds to give to investors,

the SEC would like to hear those ideas.

• Should the SEC require funds to

disclose standard deviation or duration

or any other specific risk measures?

Why or why not?

Should mutual funds rank their risk

levels? The SEC is considering whether

it would be useful and practical for

mutual funds to rank various aspects of

risk. For example, bond funds could be

required to tell investors whether their

exposures to interest rate changes,

default risks, and currency fluctuations

are low, medium, or high. This could be

done in the form of a chart like the

following.

RISK SUMMARY

Portfolio Interest

rate risk

Default

risk

Currency

risk

High-Yield

Fund.

Medium High ..... Low.

Global

Bond

Fund.

Medium Medium High.

MortgageBacked

Security

Fund.

High ..... Low ...... Low.

• Would it be useful for funds to rank

various aspects of risk? Do you find the

above chart helpful? Do you understand

the types of risk referred to in the chart

and the significance of those risks?

How to mail your ideas and

suggestions to the SEC:

• This form can be mailed to the SEC

by folding it in half, with the return

address showing. Please staple or tape

this form closed. No postage is

necessary.

• If you do not wish to use this form,

you can write a letter directly to the

SEC. Mark your letter ‘‘File No. S7–10–

95,’’ and send it to Jonathan G. Katz,

Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W.,

Washington, D.C. 20549.

• Remember to send your ideas and

suggestions by July 7, 1995.

Do you want further information

about what the SEC is considering?

• If you would like a copy of the

complete SEC release that describes

what the SEC is considering, write to

Office of Consumer Affairs, Securities

and Exchange Commission, Attn:

Michael Strupp, Mail Stop 2–6, 450

Fifth Street, N.W., Washington, D.C.

20549.

Thank you for responding.

Your Name lllllllllllllll

Street Address llllllllllllll

City llllllllllllllllll

State llllllllllllllllll

Zip lllllllllllllllllll

[FR Doc. 95–8143 Filed 4–3–95; 8:45 am]

BILLING CODE 8010–10–P