Coalition of Mutual Fund Investors
February 23, 2004
Mr. Jonathan G. Katz
Subject: Concept Release: Request for Comments on Measures to Improve Disclosure of Mutual Fund Transaction Costs/File No. S7-29-03
Dear Mr. Katz:
The Coalition of Mutual Fund Investors ("CMFI" or "Coalition") is pleased to submit the following comments regarding the Concept Release issued by the Securities and Exchange Commission ("SEC" or "Commission") on December 18, 2003, proposing measures to improve disclosure of mutual fund transaction costs.
CMFI is an Internet-based shareholder advocacy organization representing the interests of individual mutual fund investors. The Coalition is based in Washington, D.C., with a Web site that can be accessed at www.investorscoalition.com.
The Coalition applauds the Commission for attempting to improve investor disclosure of these costs. As the Commission notes in its explanatory materials accompanying this Release, current disclosure requirements do not provide adequate information about an investor's overall transaction costs.
This issue must be addressed because brokerage commissions and other portfolio transaction costs are the largest expense not reflected in the expense ratio of a mutual fund. For these reasons, CMFI strongly supports more transparent disclosure of these costs.
Under current SEC rules and Generally Accepted Accounting Principles ("GAAP"), the brokerage commissions actually paid by a mutual fund are not disclosed as an operating expense or in the expense ratio calculation provided to investors. Instead, the cash amount paid for brokerage commissions is disclosed annually in the fund's Statement of Additional Information ("SAI"). Unfortunately, this number has little value to an investor unless it is compared to the average net assets of the mutual fund and converted into a percentage ratio.
The difficulty of properly measuring transaction costs is further complicated by the fact that mutual funds do not always pay a cash commission to transact in portfolio securities. For example, stocks purchased on the NASDAQ exchange and many bonds are commonly traded via a bid/ask spread, with brokers and other transaction intermediaries being compensated by the difference between the price offered by the buyer (the "ask") and the price offered by the seller (the "bid"). This price spread "cost" is not considered a cash commission payment and so it is not disclosed in the Statement of Additional Information. Instead, the higher price paid by the buyer and the lower price received by the seller are reflected in a fund's capital returns over time.
Another measurement problem in this area is how to evaluate the indirect costs of portfolio trading. For example, a mutual fund which seeks to purchase a large block of an illiquid security may have a "market impact" cost if its own actions raise the price of the security, as it accumulates its position. Similarly, a mutual fund which expects to have a certain level of redemptions in its shares may need to retain a larger cash balance, creating an "opportunity" cost for this uninvested amount. And this "opportunity" cost will be higher for those funds with excessive market timing activities, thereby reducing the returns of longer-term shareholders.
As a goal, it is important that the SEC develop a standardized transaction cost measure that is accurate, comparable, and not overly burdensome for mutual funds. However, this process may take several years to complete and, in the interim, something should be done to improve the disclosures that investors now receive of portfolio transaction costs.
The Coalition urges the Commission to act immediately to require improved investor disclosure of the actual brokerage commissions paid in cash by each mutual fund, a dollar figure which, as noted above, is currently disclosed in a fund's Statement of Additional Information. For comparison with other funds, this figure should be converted into a percentage of average net assets of the fund and disclosed to investors as a transaction cost ratio.
Since transaction costs are not a GAAP expense and are not included in the expense ratio of a fund, CMFI believes that the simplest approach for the SEC to consider is to present these costs as a separate ratio.
To calculate this proposed transaction cost ratio, a fund would take the amount of aggregate brokerage commissions paid each year and divide this amount by the average net assets of the fund over the same one-year time period. In presenting this new cost ratio, a mutual fund would be able to explain in a footnote why the actual cost of securities transactions could be higher or lower, because of the purchase of over-the-counter ("OTC") equities, bonds, and other portfolio transactions purchased on a spread basis.
An obvious flaw in the calculation of this proposed ratio is the fact that it does not include these bid/ask spread transactions. To address this issue, the Coalition recommends that the SEC consider the following additional steps:
1. For those securities in which the exact "spread cost" is currently allocated to the buyer and the seller (e.g. NASDAQ National Market transactions), the SEC should require that this amount be recorded on the fund's brokerage confirmation statement. This "cost" to the fund can then be summed over the same one-year period as cash brokerage commissions, divided by net average assets, and added to the proposed transaction ratio proposed above.
2. For those securities in which a "spread cost" is not specifically allocated to the buyer and the seller in a transaction (e.g. certain OTC equities and bonds), CMFI recommends that the "spread cost" be defined as a exact dollar amount, allocated evenly between the buyer and the seller, and recorded on a fund's brokerage confirmation statement. This "cost" can be summed over the same one-year period as cash brokerage commissions and any other spread costs, divided by net average assets, and added to the proposed transaction ratio figure. As an alternative, mutual funds could be required to estimate their spread cost for these trades using average commission rates or some other comparable measure.
If the Commission agrees to adopt a transaction cost ratio which includes bid/ask spread transactions, a footnote or legend should be added to any disclosure of this figure, stating that this calculation is presented to provide investors with an estimate of direct brokerage costs for the period involved. A further notation should be made that this ratio does not include other indirect investor transaction costs, including market impact and opportunity costs.
The SEC should continue its efforts to develop a methodology to calculate and present market impact and opportunity costs in a standardized and comparable manner. Once an acceptable measure is developed to calculate and compare these costs, the amounts can be added to the proposed transaction cost ratio in the future. However, it will take some time to develop the methodology for such a measure; investors should not have to wait until a more perfect formulation of transaction costs is developed.
As legendary investor Warren Buffett is fond of saying: "It is better to be approximately right than precisely wrong". Mr. Buffet was referring to the inadequacies of "beta" as a financial measure in this quote, but the analogy is quite appropriate when applied to the issue of trying to measure portfolio transaction costs.
Most of the information required to calculate commission and spread costs is available today, with current technology and trading practices. The Commission should work to develop a transaction cost ratio that includes this information, recognizing that the ratio will be an estimate of the direct costs, and it will not include, for the present, an accurate measure of the indirect costs, such as market impact or opportunity costs.
CMFI believes that this proposal strikes the proper balance between the need for additional investor transparency of transaction costs and the complexity involved in identifying and measuring all transaction costs.
If a transaction cost ratio is developed by the SEC, CMFI advocates that this new ratio be disclosed in the same manner and the same location as the expense ratio, with qualifying language that informs an investor of the measurement strengths and weaknesses of the ratio.
Regarding other issues presented in the Concept Release, CMFI provides the following comments:
1. Accounting Issues. CMFI does not currently advocate a change to the accounting treatment of transaction costs. This area of accounting is quite complex and many of the proposals for change may have unintended consequences. In CMFI's view, the best mechanism to improve investor disclosure and awareness about transaction costs is to create a transaction cost ratio which captures as much information as can be measured under current standards and practices.
2. Portfolio Turnover. Many industry commentators maintain that portfolio turnover information serves as a proxy for fund transaction costs. While CMFI supports this notion generally, a requirement to provide more visibility of portfolio turnover information in investor disclosure documents should not be the only action taken by the Commission to address this issue. In other words, portfolio turnover information is helpful to an investor, but it is not going to provide a complete solution.
3. Average Net Flows Information. CMFI supports disclosure of additional information about the sale and redemption of a fund's shares. Specifically, CMFI supports the disclosure of average daily net flow as an additional tool for investor evaluation of trading activity and costs.
4. Disclosure of Gross Returns. CMFI supports the Commission proposal to disclose gross investment returns of mutual funds. Among other benefits, this additional disclosure will help investors develop a more accurate side-by-side comparison of fund performance against the performance of unmanaged indexes. This comparison is currently an "apples to oranges" comparison since fund performance is presented on a net basis, while index performance is reported on a gross basis.
Thank you for providing CMFI with the opportunity to present its views on these issues. If you or any member of the Commission staff have any questions or need additional information from CMFI, please contact me at 202-783-5300.