Advisers should be supporting transparency

The Securities and Exchange Commission reportedly is preparing rules to increase disclosure of mutual fund holdings, and investment advisers should support any such proposal.

The proposed increase in transparency is part of the SEC’s effort to determine the level of risk that mutual funds and exchange-traded funds pose to the financial system. It is being considered after the mutual fund industry fought off efforts to bring large companies under Federal Reserve oversight.

According to reports, the mutual fund companies would have to give the SEC more detailed information about the securities held in their mutual fund or ETF portfolios, with particular emphasis on the use of futures or short sales.

The SEC is concerned that the use of derivatives to improve returns also heightens the risks to the mutual fund companies and, ultimately, the financial system.

Enhanced disclosure could lead to limits on the use of derivatives by mutual funds and ETFs if the SEC determines they are taking on inappropriate and unwarranted levels of risk.

However, the potential disclosure rules should also help investment advisers do a better job of matching clients’ risk tolerance and particular mutual funds — assuming that the SEC will publish the new fund reports as it does the quarterly holdings reports now.

DETERMINING RISK

Investment advisers currently must rely on historic measures such as beta and standard deviation to determine the riskiness of a mutual fund or ETF portfolio.

That’s fine for plain-vanilla funds, but it is insufficient for some of the newer funds and ETFs that use derivatives.

Many investors are willing to use the newer investment vehicles for at least part of their portfolios. Clients have learned more about them, and some of the products have achieved better returns than have been available in the stock and bond markets over the past few years.

But clients need guidance from their investment adviser to coordinate their risk tolerance with the new style of mutual funds and ETFs.

The new information the SEC reportedly will seek from investment companies — including BlackRock Inc., Fidelity Investments, the Vanguard Group Inc., and Pacific Investment Management Co. — could help investment advisers keep their clients from taking excessive and unrecognized risk.

Advisers should respond to any request for comments from the regulator. They should not only support greater disclosure from the asset management companies but urge that the reported information be made public on a timely basis.

Asset managers might object to timely disclosure, arguing that it could involve revealing their proprietary investment strategies.

But there’s a response to that argument: No investment strategy remains secret for long in capital markets that are highly efficient in ferreting out information.

The SEC should use any data gained from enhanced disclosure about mutual fund and ETFs’ use of derivatives to better understand the connections between the fund industry and the capital markets.

The transmission mechanism among mutual fund investors, mutual funds and the broader capital markets is not as direct as it might appear.

That is demonstrated by the fact that the 2008 financial crisis neither sparked mass exits from mutual funds, nor caused the collapse of any major stock or bond fund, or ETF company.

The SEC should keep those facts in mind as it studies new information gathered from the asset management industry and contemplates new regulations.