(Article from Registered Funds Alert, June 2018)
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In April 2018, the Investor Protection Bureau of the Office of the New York Attorney General (“NYAG”) released its findings and recommendations following an investigation into mutual fund fees. The investigation resulted in pressure on mutual fund firms to disclose to retail investors more information about just how “active” their management is with respect to actively managed funds. Specifically, the NYAG reached an agreement with several large mutual fund firms in which the firms agreed to publicly publish a metric known as “Active Share.” This metric purports to measure the difference between a mutual fund’s holdings and the holdings of its benchmark index based on the number of issuers and the weight of each holding in the fund’s portfolio compared to the weight of each holding in the benchmark’s portfolio.
The NYAG’s initiative reflects two significant trends in the asset management industry: (i) state governments stepping in to regulate the industry, claiming that the SEC is abdicating its role; and (ii) the battle between active and passive funds for retail investments. In support of this Active Share campaign, now-former Attorney General Eric Schneiderman stated that public disclosure of this new metric will allow retail investors to make more informed decisions prior to investing in a mutual fund by helping them determine if a fund’s high fee is appropriate based on its level of active management. Although the NYAG insists that the Active Share metric is a necessary tool, it is unclear how retail investors will actually benefit from this disclosure. Indeed, there is a risk that investors may end up putting too much emphasis on the Active Share metric at the expense of other relevant factors that influence a fund’s fee rate.
The NYAG was prompted to conduct this industry-wide investigation due to the popularity of actively managed mutual funds despite the fact that they charge higher fees than passively managed mutual funds. As part of its investigation, the NYAG surveyed several mutual fund firms that manage more than 2,000 actively managed mutual funds. The survey sought to determine whether and how these firms use the Active Share metric, and whether the Active Share metric is publicly disclosed to investors. The NYAG found that every surveyed firm used the Active Share metric in some capacity—including measuring risks for an individual fund, setting informal targets for portfolio managers, selecting and assessing performance of portfolio managers and sub-advisers—and that every firm disclosed Active Share information to institutional investors in presentations or pitch books (or at least upon request). In contrast, the NYAG found that only four of the 14 surveyed firms provided any Active Share information to their retail investors, either on the firm’s website or in supplemental data sheets posted online.[1]
Following the NYAG’s investigation, all of the surveyed firms that were not already publishing Active Share data have agreed to publish the information on their websites for their actively managed mutual funds. Although the NYAG’s recommendation did not include a compliance date for mutual fund firms, this disclosure should soon, if not already, be available to U.S. investors.[2] The NYAG urged all mutual fund firms to follow suit and recommended that retail investors take advantage of this new information when deciding whether an actively managed mutual fund’s fee is acceptable based on the level of the fund’s overlap with its benchmark.
The investigation is part of a long history of state governments getting involved in regulating the mutual fund industry
In its politically charged report, the NYAG explained that it was prompted to conduct its investigation in part because of the increasing complexity surrounding mutual fund market and the NYAG’s view that the federal government has rolled back protections designed to heighten the duty of care owed to investors and address investment advisers’ conflicts of interest. Specifically, the NYAG’s report noted the uncertainty concerning the future of the Department of Labor’s Fiduciary Rule, including the inconsistent decisions from federal appellate courts regarding the validity of the rule and the Trump administration’s decision to delay the enforcement of the rule until July 2019. The report also noted the SEC’s inaction with respect to implementation of a uniform best interest standard.[3] The NYAG believes that pervasive, unaddressed conflicts of interest, especially in the retirement advisory business, could cost investors between $95 billion and $189 billion over the next 10 years. In light of these issues, the NYAG believes that disclosing Active Share information will give retail investors the tools they need to be more vigilant in evaluating investment choices and recommendations from their investment advisers. Assuming for the sake of argument that the claim of harm is true, it is difficult to understand how Active Share disclosure would cure it.
State governments’ involvement in regulating the asset management industry is not novel. Beginning in 2003, Eliot Spitzer, New York’s Attorney General at the time, investigated several mutual fund and hedge fund firms in an attempt to crack down on alleged widespread illicit trading practices, specifically late trading and market timing. The probe ultimately resulted in settlements with a number of firms. Mr. Spitzer’s findings from these cases also convinced both the SEC and the Commonwealth of Massachusetts to launch their own investigations into hedge fund and mutual fund practices, and the SEC agreed to work with Spitzer on his probe. Also at that time, William F. Galvin, the Massachusetts Secretary of the Commonwealth, launched a joint inquiry with Mr. Spitzer into a firm’s sale of proprietary mutual funds to investors who were not aware that brokers received additional compensation for selling such funds, which ultimately led to a settlement. The inquiry not only focused on the firm’s practice, but also sought to determine if other firms had similar practices. Commentators at the time asserted that the SEC was lagging Mr. Spitzer’s aggressiveness with investigating conflicts of interest in the asset management industry, although the SEC insisted that it had not been made aware of these allegations until Mr. Spitzer filed his complaints.
Given assertions by certain state regulators that the Trump administration is seeking to roll back and/or halt the federal regulatory process, state governments likely will seek to increase efforts to extend their authority over the asset management industry and could cause significant headaches and burdens for the industry if responding to inquiries from a patchwork of state regulators.
The investigation reflects the ongoing battle between passively managed and actively managed mutual funds
Another major factor that the NYAG claimed prompted its investigation into the mutual fund industry was a desire to better understand whether actively managed funds’ significantly higher advisory fees correlate with higher levels of active management. The NYAG found that actively managed funds cost 4.5 times more than passively managed funds. The NYAG compared each fund’s Active Share metric to its advisory fee and discovered that funds charged a wide range of fees for the same level of active management. The NYAG concluded that investors could not assume that the higher fees reflected the funds’ opportunity to outperform their benchmarks through more active management. The NYAG’s comparison, however, contains a flawed assumption (discussed further below) that the only way to outperform a benchmark is to have little overlap with it.
The NYAG’s report highlights the ongoing battle between passively managed and actively managed funds for investors’ dollars. The NYAG’s report noted that by 2016, nearly half of all U.S. households invested in mutual funds, either directly or indirectly through an employer’s 401(k) plan. Although most investors choose to invest in passively managed funds, actively managed funds still remain a popular option for investors looking for an opportunity to outperform a benchmark, despite the higher fees charged for such funds. Some critics, however, believe that some actively managed mutual funds are merely index funds in disguise. At this point, it is unclear how much weight investors put on the Active Share metric and whether this new disclosure will impact actively managed fund flows.
The Active Share metric is unlikely to be as informative for retail investors as the NYAG expects
Although the NYAG concluded that disclosure of Active Share information is critical to close the information gap that hinders retail investors’ ability to make informed investment decisions, the disclosure of Active Share information in practice likely is not as informative as the NYAG believes. In the NYAG’s view, investors cannot look at a mutual fund’s advisory fee alone to determine its level of active management and, in turn, its potential to generate better returns compared to its benchmark or avoid losses. The NYAG’s report recommends that retail investors use the Active Share metric when evaluating investment options, but fails to explain how investors should use this information and does not recommend that investors view the Active Share metric as only one of a number of factors relevant to evaluating a mutual fund.
Despite the level of importance the NYAG attached to the Active Share metric, its agreements with the mutual fund firms only require this metric to be updated quarterly, as opposed to daily. As such, the Active Share metric is only providing retail investors with a snapshot of the mutual fund’s active management at one point in time, which is unlikely to paint an accurate picture of the actual extent of active management for a fund. Certain mutual fund firms may decide to publish more frequent Active Share information or historical Active Share information, either in the spirit of transparency or in order to highlight their active management to retail investors. In addition, the NYAG’s report only acknowledges that the Active Share metric may be less relevant when comparing different types of mutual funds, such as those with different market-caps. It does not recognize that the Active Share metric may be far less useful for funds with flat benchmark indexes, such as the Russell 2000, or when comparing funds that utilize different strategies in their active management (e.g., sector, geographic or momentum strategies). It remains to be seen if retail investors will actually appreciate these limitations of the Active Share measure.
Finally, too much emphasis on the tenuous link between the Active Share metric and investment advisory fees may encourage plaintiffs to pursue frivolous excessive fee lawsuits. While the NYAG’s report appears to suggest that a high advisory fee for an actively managed fund is not justified if the fund has a low Active Share metric, a fund’s advisory fee involves many other considerations beyond the amount of active management, such as the level of complexity involved with a particular strategy. If investors do not appreciate the intricacies involved in setting a fund’s advisory fee, they may jump to the conclusion that a high advisory fee is not warranted based solely on the Active Share metric.
In light of Mr. Schneiderman’s recent resignation, the future of the NYAG’s Active Share campaign is uncertain. However, there regrettably has been no indication that his replacement will take a more cautious, thoughtful approach into inserting the NYAG into the regulation of actively managed mutual funds.
[1] The report noted that some firms provided the Active Share information to retail investors through brokers and other intermediaries, but only upon request.
[2] Eight of the firms have already published their Active Share data either on their website, through a fund fact sheet or in a quarterly statistic report for each relevant fund.
[3] The NYAG report predated the SEC’s recent proposals regarding the standards of care for broker-dealers and investment advisers, which are discussed elsewhere in this Alert.