The Securities and Exchange Commission Division of Investment Management staff recently issued a Guidance Update to remind mutual funds, exchange traded funds, and other registered investment companies of the importance to investors of full and accurate information about fund risks, including risks that arise because of changing market conditions. The Guidance Update advises funds to review their risk disclosures on an ongoing basis to consider whether the disclosures remain adequate.
Importance of Robust Risk Disclosure
The Guidance Update discusses the importance of fund risk disclosure and how to use risk disclosure to address changing market conditions, including changes in a fund’s susceptibility to risk that may result from changes in market conditions. The staff acknowledges that degree of risk is dynamic in nature rather than static, that a fund’s risks may change in response to market conditions, and that different risks may be heightened or lessened at different points in time. Therefore, if a fund determines that its risk disclosure is not currently adequate, the fund should consider how to appropriately communicate changed risks to existing and potential investors, such as in the fund prospectus or other offering materials, in shareholder reports, on the fund’s website, and/or in fund marketing materials. The staff also points out that the fund’s adviser should consider providing the fund board with information on the steps the adviser has taken to evaluate risk disclosures and whether changes are appropriate.
The Guidance Update suggests that funds undertake the following three steps on an ongoing basis to help provide risk disclosures to investors that remain robust in changing markets:
- Monitor market conditions and their impact on fund risks. A fund should monitor market conditions on an ongoing basis and assess how changing conditions affect the fund and the risks associated with its investments. Monitoring market conditions for their impact on the fund is a part of prudent portfolio management by the adviser, so this practice should be part of day-to-day operations.
- Assess whether fund risks have been adequately communicated to investors in light of current market conditions. If a fund determines that changed market conditions have affected the risks associated with the fund, the fund should assess the significance of the change and whether it is material to investors. The fund should then consider whether its existing disclosures are adequate in light of the changed conditions.
- Communicate with investors. If a fund concludes that changes in current market conditions have resulted in changes to the fund’s risks that are material to investors, and that its current disclosures do not adequately communicate the changes, the fund should provide updated communications to investors at the time and in the manner required by the federal securities laws and as otherwise appropriate. Means of communication to be considered include the prospectus (which, for example, would be updated when the fund determines that the risk disclosure in its prospectus would be materially misleading) and shareholder reports, as well as less formal methods, such as website disclosure, or letters to shareholders.
Guidance for Registered Funds
The Guidance Update reiterates that clear and accurate disclosure of the risks of investing in funds is important to informed investment decisions and, therefore, to investor protection. Form N-1A, for example, requires mutual funds to summarize in the summary prospectus the principal risks of investing in the fund, including the risks to which the fund’s portfolio as a whole are subject and the circumstances reasonably likely to affect adversely the fund’s net asset value, yield, and total return. The fund’s statutory prospectus must provide a fuller description of the principal risks of investing in the fund, not simply a repeat of the summary. The Guidance Update points out that the staff previously has:
- Emphasized the importance of providing a concise summary of principal investment risks, rather than a long, complex, and detailed description of those risks, in the summary section of the prospectus.
- Encouraged any fund that exposes investors to market, credit, or other risks, and whose name suggests safety or protection from loss, to reevaluate the name and to consider changing it, as appropriate, to eliminate the potential for investor misunderstanding.
- Noted important aspects of disclosures related to fund use of derivatives, including the staff’s expectation that a fund that uses investment strategies that employ derivatives should disclose material risks relating to volatility, leverage, liquidity, and counterparty creditworthiness associated with the fund’s trading and investments in derivatives.
Examples of Risk Disclosure
The Guidance Update also discusses in some detail specific examples of risk disclosures related to current market conditions, including disclosures for fixed income funds related to interest rate risk, liquidity risk, and duration risk, as well as risks relating to investments in Puerto Rico debt.