[Federal Register Volume 60, Number 64 (Tuesday, April 4, 1995)]
[Proposed Rules]
[Pages 17172-17181]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-8143]




[[Page 17171]]

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Part V





Securities and Exchange Commission





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17 CFR Part 239 et al.



Improving Descriptions of Risk by Mutual Funds and Other Investment 
Companies; Proposed Rule

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

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.

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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\

    \1\See, 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).
    \2\The 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''].
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    Under existing SEC rules, a fund is required to discuss in its 
prospectus the principal risk factors associated with investing in the 
fund.<SUP>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.<SUP>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.<SUP>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.

    \3\Risk 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 & 
274.11a-1] (closed-end funds).
    \4\See 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).
    \5\See 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).
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    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.<SUP>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.<SUP>7 Second, [[Page 17173]] 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.<SUP>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.<SUP>9

    \6\According 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.
    \7\See, e.g., Burton G. Malkiel, A Random Walk Down Wall Street 
ch. 13 (1990) [hereinafter ``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.
    \8\See 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.
    \9\See, 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).
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    The importance of risk disclosure was underscored last year when 
some short-term government bond funds experienced losses as interest 
rates increased sharply.<SUP>10 Shareholders in these funds expressed 
surprise at the losses, and several shareholder lawsuits were 
filed.<SUP>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.

    \10\See, 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.
    \11\See, 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.
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    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 risk-adjusted 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:
    <bullet> The benefits to be derived from quantitative measures 
versus the costs and burdens to the fund that must produce such 
information;
    <bullet> Quantitative measures currently used by fund managers to 
assess risk, and whether such internally used measures should be 
disclosed to investors;
    <bullet> Investor understanding of quantitative measures, and means 
to increase that understanding;
    <bullet> Standardizing the ways in which funds calculate 
quantitative measures to assure comparability and the validity of any 
underlying assumptions; and
    <bullet> 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?<SUP>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?

    \12\See 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 long-term investor, stocks will outperform bonds or cash).
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    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?<SUP>13 
In [[Page 17174]] light of the substantive limits on permitted money 
market fund investments,<SUP>14 should risk disclosure requirements for 
money market funds be different from those applicable to other 
funds?<SUP>15

    \13\See 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 
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.
    \14\Mutual 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).
    \15\Losses 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, 
Sec. 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).
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    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.<SUP>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?

    \16\See Derivatives Report, supra note 5, at 11.
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II. Narrative and Non-Narrative Risk Disclosure Options

    The SEC currently requires fund prospectuses to include narrative 
descriptions of risk,<SUP>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.

    \17\See supra notes 3 and 4 and accompanying text.
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    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.<SUP>18 Recently, the SEC adopted rules that 
require graphic depictions of information to facilitate investor 
understanding of fund performance.<SUP>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?

    \18\For 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).
    \19\See 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)].
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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 risk-adjusted 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, risk-adjusted 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.
    <bullet> 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.<SUP>20 For 
example, a fund's [[Page 17175]] 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.

    \20\William F. Sharpe, Gordon J. Alexander, and Jeffery V. 
Bailey, Investments 178 (5th ed. 1995) [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 x 4%)) and 9% (1%+(2 x 4%)) if the 
returns were ``normally'' distributed. See Sharpe, Alexander, & 
Bailey, supra, at 177.
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    <bullet> 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.<SUP>21 Semi-variance, which can be 
used to measure the variability of returns below the average return, 
reflects this view of risk.<SUP>22 A fund with a larger semi-variance 
has returns that are more spread out below the average return.

    \21\See Sharpe, Alexander, & Bailey, supra note 20, at 178; 
Allan Flader, ``Deviating from the Standard,'' Financial Planning, 
June 1994, at 148.
    \22\Funds' 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.
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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.<SUP>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, so-called ``market risk,'' cannot be eliminated through 
diversification.<SUP>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.

    \23\Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments 197 
(2d ed. 1993) [hereinafter ``Bodie, Kane, & Marcus''].
    \24\Bodie, Kane, & Marcus, supra note 23, at 197-99; Sharpe, 
Alexander, & Bailey, supra note 20, at 212-17.
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    <bullet> 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).<SUP>25

    \25\Sharpe, Alexander, & Bailey, supra note 20, at 211; Frank J. 
Fabozzi and Franco Modigliani, Capital Markets: Institutions and 
Instruments 136-40 (1992) [hereinafter ``Fabozzi & Modigliani''].
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    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.
    <bullet> Duration.<SUP>26 Duration is a measure of the price 
sensitivity of a bond, or bond portfolio, to interest rate 
changes.<SUP>27 There are different types of duration,<SUP>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?<SUP>29

    \26\The 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, Sec. 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.
    \27\Bodie, 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.
    \28\For 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.
    \29\Fabozzi & 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%.
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    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.<SUP>30 Fourth, bond value 
changes resulting from interest rate changes are sometimes poorly 
predicted by duration.<SUP>31

    \30\See 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.
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    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 ``short-term'' or ``long-term,'' the dollar-weighted 
average portfolio maturity of the portfolio must reflect that 
characterization.<SUP>32 The SEC requests [[Page 17176]] 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.

    \32\See, 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).
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3. Risk-Adjusted Measures of Performance<SUP>33

    \33\The SEC has solicited comment on risk-adjusted 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).
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    Risk-adjusted measures of performance were developed in the 1960s 
to compare the quality of investment management. Three widely-used 
risk-adjusted measures are:
    <bullet> Sharpe Ratio.<SUP>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'')<SUP>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.

    \34\See 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''].
    \35\The yield on 90-day Treasury bills is often used as a proxy 
for the risk-free rate of return.
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    <bullet> Treynor Ratio.<SUP>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.

    \36\See 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.
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    <bullet> Jensen's Alpha.<SUP>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.<SUP>38 Jensen's Alpha measures the ability of 
active management to increase returns above those that are purely a 
reward for bearing market risk.

    \37\Michael 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.
    \38\For 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.
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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,<SUP>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.<SUP>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?<SUP>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?<SUP>42

    \39\Form N-1A, Item 3; Form N-2, Item 4.
    \40\For 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.
    \41\See Form N-1A, Item 3; Form N-2, Item 4 (financial 
highlights table).
    \42\See 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).
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    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 [[Page 17177]] 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 over-reliance?
    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 portfolio-based computation, which calculates a 
portfolio risk measure based on the particular securities in the 
portfolio as of a specified measurement date.<SUP>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.

    \43\See, e.g., Comptroller of the Currency, Risk Management of 
Financial Derivatives 49-53 (Oct. 1994); J.P. Morgan, Introduction 
to RiskMetrics<SUP>TM (2d ed.) (Oct. 25, 1994); Group of Thirty, 
Derivatives: Practices and Principles 10-11 (July 1993).
---------------------------------------------------------------------------

    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.<SUP>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.<SUP>45

    \44\The 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).
---------------------------------------------------------------------------

    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? [[Page 17178]] 
    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.<SUP>46 In 
addition, some organizations disseminate fund performance ratings that 
take risk into account<SUP>47 or fund risk ratings.<SUP>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.

    \46\See, 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.
    \47\See, 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.
    \48\These 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.
---------------------------------------------------------------------------

    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] * * *.''<SUP>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.

    \49\Investment Company Act Sec. 30(b) [15 U.S.C. 80a-29(b)].
---------------------------------------------------------------------------

    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.<SUP>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.

    \50\Nationally 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.
---------------------------------------------------------------------------

IV. Narrative Disclosure Options

    The SEC asks for comment on the usefulness to investors of 
narrative risk disclosure currently found in prospectuses.<SUP>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?

    \51\See discussion supra notes 3-5 and accompanying text.
---------------------------------------------------------------------------

    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,<SUP>52 
annual [[Page 17179]] 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?

    \52\Mutual 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)]. Post-effective 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 continuous basis, they generally do not 
update their prospectuses periodically.
---------------------------------------------------------------------------

    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?<SUP>53

    \53\Cf. 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).
---------------------------------------------------------------------------

    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.<SUP>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?

    \54\Form N-1A, Item 5A.
---------------------------------------------------------------------------

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.<SUP>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.

    \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.
---------------------------------------------------------------------------

    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.<SUP>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.

    \56\Investment Company Act rule 0-10 [17 CFR 270.0-10].
---------------------------------------------------------------------------

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 [[Page 17180]] 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.
    <bullet> 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.
    <bullet> 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.
    <bullet> 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?
    <bullet> 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?
    <bullet> 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.
    <bullet> 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?
    <bullet> 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?
    <bullet> 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.
    <bullet> 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.

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[[Page 17181]]

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BILLING CODE 8010-01-C
    <bullet> 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:
    <bullet> 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.
    <bullet> 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.
    <bullet> 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                              
------------------------------------------------------------------------
                                    Interest     Default                
            Portfolio               rate risk     risk     Currency risk
------------------------------------------------------------------------
High-Yield Fund..................  Medium....  High......  Low.         
Global Bond Fund.................  Medium....  Medium....  High.        
Mortgage-Backed Security Fund....  High......  Low.......  Low.         
------------------------------------------------------------------------

    <bullet> 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:
    <bullet> 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.
    <bullet> 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.
    <bullet> Remember to send your ideas and suggestions by July 7, 
1995.
    Do you want further information about what the SEC is considering?
    <bullet> 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.

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