Prompted perhaps by the explosion of “ESG” funds that may or may not actually invest in low carbon firms or ones with better “S” or “G”, the SEC issued a new names-rule to address labelling challenges with mutual funds, ETFs, unlisted closed end funds and BDCs (business development corporations). The fund industry is simply massive and deserves more research and airtime in governance circles than it currently gets, in my view. Page 117 of the SEC’s names rule states that, as of July 31, 2021, there were 10,223 mutual funds (excluding money market funds) with approximately $18,588 billion in total net assets, 2,320 ETFs with approximately $6,447 billion in net assets, 736 closed end funds with net assets of $314 billion and 49 UITs (unit investment trusts) with net assets of $598 billion. Wow!
Let us start with an overview of what the rule proposes before reflecting on its implications.
The key features of the new names proposal are as follows:
- 80% rule
Funds are required to adopt a policy of investing at least 80% of their assets in accordance with the investment focus that the fund’s name suggests. The new rule, in essence, extends the older 80% rule to any fund name with terms suggesting an investment focus with particular characteristics. Earlier, fund names with terms such as “growth” and “value” that connote an investment strategy were exempt from the 80% rule. Not anymore. This is a welcome development considering the general ambiguity associated with what these labels mean, an issue I had raised earlier.
- Temporary departures
Deviations from the 80% policy under normal circumstances are allowed under the old rule. The new rule follows less of a principles-based approach by specifying circumstances where such departures are explicitly allowed (address unusually large cash inflows or large redemptions, to take a position in cash or government securities to avoid a loss because of market conditions or a reorganization) and how soon compliance needs to be restored (30 days).
- Notice in case of change
The fund needs to provide shareholders a notice at least 60 days prior to any change in its 80% investment policy.
- 80% rule not a safe harbor
The new rule states that compliance with the 80% policy is not intended to be a safe harbor for materially deceptive or misleading names. More on that later, especially with reference to funds holding an index.
- Notional value of derivatives
Under the new rule, funds need to use the notional value, as opposed to the market value, of any derivatives they hold to check compliance with the 80% investment policy. I understand the SEC’s concern that a fund with emerging market debt in its name could say invest 80% of its assets in emerging markets but use derivatives to obtain substantial investments in U.S. equities. If the fair value of the derivatives used for the 80% test, the fund will pass that test as the fair value of its U.S. bet is much smaller than the emerging market investment.
Having said that, this still sounds odd to me. What if the derivatives were used to bet on emerging markets debt for instance? We would have met a more than say 110% assets in the basket requirement. Is that a good outcome necessarily?
Notional values are orders of magnitude larger than market or fair values of those derivatives. Hence, we run the risk of whacky outcomes when notional values are considered. Yes, funds will probably stop speculating in unrelated investments. Do we run the risk of unintended consequences of hurting risk management uses of derivatives? Do we fully understand why funds use derivatives in the first place? Is this more of a governance issue best left to the fund’s board? Alternatively, have funds clearly state their policy on using derivatives in the prospectus and police that disclosure?
- Closed end funds
Because investors lack easy exit as a remedy, unlisted closed end funds and BDCs are not permitted to change their 80% investment policies without a shareholder vote.
- Define terms in name in the prospectus
The fund’s prospectus needs to define the terms used in the name. I like this idea.
- Plain English meaning
The fund’s name must be consistent with those terms’ plain English meaning or established industry use. This is sensible as well. For instance, “ABC solar fund,” is expected to invest in solar technology and not carbon capture technology for instance. If the fund wants to do so, it may have to rename itself as “ABC solar and carbon capture fund.” Some will argue this is onerous but labels need to have some integrity for the system to work and have credibility.
- Impact on names of ESG funds
The SEC has come down harder on ESG funds. They define “integration” funds as materially deceptive if the name indicates that the fund’s investment decisions incorporate one or more ESG factors although ESG factors are not determinative in picking an investment. In essence, integration funds cannot use the term ESG in their names. Only ESG-focused and ESG impact funds can. This is a significant strike against at least “name washing” in the wild world of ESG.
On page 26, the rule seems to suggest that “XYZ ESG fund” must adopt an 80% investment policy to address all three of those elements although the SEC recognizes that there are multiple reasonable ways the policy could address these elements. This is an interesting development given the over-emphasis on E in most conversations and metrics about ESG.
- Reporting to the SEC
The fund needs to file a form with the SEC stating which investment they held is included in the fund’s 80% basket. This is an interesting way to help investors compare what two “value funds” actually hold given the myriad ways in which “value” can be defined and measured.
- Record why not 80%?
Funds that do not adopt an 80% investment policy are required to retain a written record of why they do not fall under the rule.
A few comments on the rule follow:
1.0 Will the new labeling rule help?
The rule is a good step in the right direction but the structural problems remain, in my view. A fund might state it follows a “fundamentals quality” strategy and 80% of its funds are indeed invested in such a strategy. Who is keeping an eye on what “fundamentals quality” means? The new definition-based requirement in the prospectus might help but I am not so sure. Here is an example of how GMO Quality Fund describes its investment objective:
GMO seeks to achieve the Fund’s investment objective by investing the Fund’s assets primarily in equities of companies that GMO believes to be of high quality. GMO believes a high-quality company generally to be a company that has an established business that will deliver a high level of return on past investments and that will utilize cash flows in the future by making investments with the potential for a high return on capital or by returning cash to shareholders through dividends, share buybacks, or other mechanisms. In selecting securities for the Fund, GMO uses a combination of investment methods and typically considers both systematic factors, based on profitability, profit stability, leverage, and other publicly available financial information, and judgmental factors, based on GMO’s assessment of future profitability, capital allocation, growth opportunities, and sustainability against competitive forces. GMO also may rely on valuation methodologies, such as discounted cash flow analysis and multiples of price to earnings, revenues, book values or other fundamental metrics. In addition, GMO may consider ESG (environmental, social, and governance) criteria as well as trading patterns, such as price movement or volatility of a security or groups of securities. The Fund may also utilize an event-driven strategy, such as merger arbitrage.”
This description is broad enough to cover most approaches of investing in general. Will the new rule make a dent here, for instance? How will anyone know for certain that GMO has or has not invested in a “quality” stock? Is this objective falsifiable with evidence? Perhaps if GMO bought stocks that have not been public for long as that would violate the “established” business idea promised in the prospectus. How much weight does GMO assign to the factors listed such as past return (what is that? Past stock returns or accounting returns? Is that return on assets or equity?), profit stability and leverage? How do they measure and think about capital allocation or growth or future sustainability? What ESG criteria do they consider? Which valuation metrics are relied on more heavily (DCF or multiples) and when?
You could counterargue that these constitute the fund manager’s secret sauce and as along as “buyer beware” applies we are all good. Perhaps. But that raises the question of how much should the funds market be policed? Are these claims verifiable at all? Does this push the responsibility for governance to the board of the fund and/or auditors? The auditors focus on whether the financial statements of GMO or the fund actually reflect the investments held and not necessarily on whether the investment process actually reflects the objectives promised to investors.
Why not allow funds to do whatever they want as long as “buyer beware” applies? Does “buyer beware” really apply with a vast majority of disperse attention-challenged retail investors? I, for one, have bought funds based on their names without digging hard into the prospectus. How much paternalism or protection should a regulator aim to provide to such retail investors?
2.0 Would fund disclosure as opposed to the 80% rule have been a better regulatory response?
Some have argued that disclosure would have been a better answer as opposed to imposing the 80% investment policy rule. I am not so sure. We have disclosures under the current regime and that has not stopped the proliferation of dubious ESG funds. I would argue that we, as a society, have over-relied on the power of disclosure to enforce governance as getting prescriptive rules passed through the political process has become harder. It is not obvious that 250-page prospectus filled with disclosure that is vague and full of legalese is necessarily superior at achieving better social outcomes than a bright line rule such as 80% in this context with dispersed and inattentive retail investors who simply send their 401(K) contributions mechanically into a mutual fund to take advantage of dollar cost averaging.
3.0 Will the 80% rule lead to more standardization in funds’ investment portfolios?
Others worry that the rule will limit market-driven choices in portfolio allocation and hence lead to too much homogeneity in holdings and limit flexibility to change strategies in response to market events. I am not so sure. Recall that we have had a 80% rule for a while now. The new proposal simply extends that rule to investment strategies.
Do we observe a lot of homogeneity in investment strategies of the funds already covered by the 80% rule? How many funds currently violate the 80% rule? I am not aware of solid empirical evidence on that question. However, I doubt that the homogeneity concern is a big issue. The 60-day advance notice requirement may be somewhat onerous in this regard but the temporary drift provision allowed by the SEC for 30 days sounds like a reasonable compromise to deal with market moving emergencies.
4.0 Should the SEC have used historical returns to exhibit minimum exposures to certain risk factors instead of the 80% assets rule?
Absolutely not, in my view. Anyone who has run these regressions of fund returns on three factors (size, market to book, momentum etc.) will tell you that these conversations will quickly degenerate into statistical maze associated with the time-period chosen to run the regression, how the breakpoints associated with high size or low size are defined and so on. A simpler test based on observed holdings of funds is so much easier for the investor to understand and for a verifier to audit. Perhaps, intermediaries such as Morningstar can run these regressions and report how heavily titled specific funds’ portfolios are with respect to size, market to book and other such factors.
5.0 Fund oversight on index algorithm or score?
On page 70, the SEC states that technical compliance with the 80% investment policy does not cure a fund name that is materially deceptive or misleading. This stipulation is especially interesting in the context of a fund that follows an index and if the underlying index contains components that are contradictory to the fund’s name. Consider a fund that follows the S&P ESG index. Note the current controversy associated with Tesla getting booted out of that index. The S&P 500 ESG leaders index includes Exxon, for instance. Their methodology excludes fossil fuel companies with relatively low S&P ESG scores. Should an ESG focused fund that relies on exclusionary screening of fossil fuel stocks hold the S&P 500 ESG leaders index or not?
At the end of the day, the fundamental building block of computers running money is an index, which in turn relies on some algorithm or a score used to construct that index. Who is responsible for governing such algorithm or score? Does a fund really have the resources to identify and resolve the inconsistency between its investment objective and the logic underlying the index or score that the fund uses?
6.0 How do other areas address their labeling problems?
Stepping back a bit, it is worth asking how other domains have addressed labeling problems. My marketing colleagues at Columbia are especially interested in this issue and I look forward to feedback from that community on the new names rule of the SEC.
Having said that, I cannot help but wonder about the maze of “organic” food labels or labels assigned to eggs in a grocery store. The USDA, which is responsible for enforcement of the “organic” label, appears to rely on a number of government and private certifiers who compete with one another to certify the label. Does anyone actually certify the “ESG Integrated” or “Value” label that funds use now? I don’t think so. Should we encourage the creation of such a certifier market? Policing the “organic” label is quite hard given the complexity of global supply chains and the emergence of foreign certifiers. The funds labeling problem sounds somewhat simpler by comparison, but it does raise the question of how audits the certifiers, even if they were to emerge.
What about labels on eggs such as “natural,” “cage free,” “free range,” “vegetarian diet-based eggs,” “pasture raised,” “organic,” “humane,” “omega3,” “farm fresh,” or “no hormones”? How are these policed? My guess is that this space is a mess. Certifications, reportedly involve the farmer filing out a form of one or two pages with minimal or no verification of those statements in those forms. Complaints associated with labeling are usually filed by activists with the USDA or the FDA (Federal Drug Administration) as the USDA regulates meat, poultry, and liquid egg products whereas the FDA oversees dairy, fish, and shell eggs. Do we have a similar complaint process for mislabeled funds?
The final option with misleading labels, of course, is litigation by animal rights groups but launching and winning lawsuits against well resourced firms is non-trivial. Will we see a similar movement against misleading fund labels by investor advocacy groups?
At the end of the day, the egg labeling problem sounds daunting. I am glad I am mostly vegan. Although, I will have to think harder about the couple of egg omelet breakfasts I have every week.
Shivaram Rajgopal is the Kester and Brynes Professor at Columbia Business School and a Chazen Senior Scholar at the Jerome A. Chazen Institute for Global Business.
This article was originally published on Forbes.com.
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