Improving Descriptions of Risk by Mutual Funds and Other Investment Companies

SUMMARY: The Securities and Exchange Commission (the ``SEC'' or

``Commission'') is seeking comments and suggestions on how to improve

the descriptions of risk provided to investors by mutual funds and

other management investment companies (``funds'' or ``investment

companies''). In order to encourage individual investor comments and

suggestions, the SEC is including in the Release an appendix directed

to investors, which the SEC intends to reprint separately and

distribute to investors.

DATES: The SEC requests comments on or before July 7, 1995.

ADDRESSES: Three copies of your comments should be submitted to

Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450

Fifth Street NW., Washington, D.C. 20549. All comment letters should

refer to File No. S7-10-95. All comments received will be available for

public inspection and copying in the SEC's Public Reference Room, 450

Fifth Street NW., Washington, D.C. 20549. If you are an individual

investor and do not have access to a copier machine, you may send in

one copy of your comments.

FOR FURTHER INFORMATION CONTACT: Susan Nash, Senior Special Counsel,

(202) 942-0697, Paul B. Goldman, Chief Financial Analyst, (202) 942-

0510, Roseanne Harford, Senior Counsel, (202) 942-0689, Martha H.

Platt, Senior Counsel, (202) 942-0725, in the Division of Investment

Management, or Craig McCann, Professional Fellow, (202) 942-8032,

Office of Economic Analysis.

SUPPLEMENTARY INFORMATION:

Executive Summary

Today the SEC is continuing its efforts to enhance the information

that investors in funds receive to assist them in making an informed

investment decision. In recent years, the SEC has taken significant

steps designed to improve the understandability and comparability of

fund disclosure of performance and expenses.\1\ The SEC is now

requesting comment on how to improve risk disclosure for investment

companies, including ways to increase the comparability of disclosure

about funds' risk levels through quantitative measures or other

means.\2\

\1\See, e.g., Disclosure of Mutual Fund Performance and

Portfolio Managers, Investment Company Act of 1940 (``Investment

Company Act'') Rel. No. 19382 (Apr. 6, 1993) [58 FR 19050 (Apr. 12,

1993)] (requiring mutual fund prospectuses or annual reports to

discuss performance and provide line graph comparing fund

performance to that of an appropriate market index over the last ten

fiscal years; financial highlights table of prospectus revised to

include total return information and generally to provide investors

with information showing the performance of funds on a per share

basis); Registration Form for Closed-End Management Investment

Companies, Investment Company Act Rel. No. 19115 (Nov. 20, 1992) [57

FR 56826, 56829 (Dec. 1, 1992)] (improvements to financial

highlights table for closed-end funds; fee table providing standard

format for expense information required in closed-end fund

prospectuses); Advertising by Investment Companies, Investment

Company Act Rel. No. 16245 (Feb. 2, 1988) [53 FR 3868 (Feb. 10,

1988)] [hereinafter ``Rel. 16245''] (mutual fund advertisements and

sales literature containing performance data required to include

uniformly computed performance data); Consolidated Disclosure of

Mutual Fund Expenses, Investment Company Act Rel. No. 16244 (Feb. 1,

1988) [53 FR 3192 (Feb. 4, 1988)] (fee table required in mutual fund

prospectuses).

\2\The SEC requested comment on methods for disclosing risk in

1993 when it proposed rule amendments that would have given

investors the option of purchasing mutual fund shares based on a

short form prospectus. Off-the-Page Prospectuses for Open-End

Management Investment Companies, Investment Company Act Rel. No.

19342 (Mar. 19, 1993) [58 FR 16141, 16145 (Mar. 25, 1993)]

[hereinafter ``Rel. 19342'']. In particular, the SEC asked whether

the short form prospectus should be required to contain a

standardized presentation of the degree and kind of risk presented

by a mutual fund relative to other mutual funds. A limited number of

comments were received on this topic, with the comments being almost

evenly divided whether standardized risk disclosure should be

required. See Summary of Comment Letters Relating to Proposed Rule

482(g) Made in Response to Investment Company Act Release No. 19342,

File No. S7-11-93, Jan. 27, 1994, at 17-18 [hereinafter ``Summary of

Comments: Rel. 19342''].

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Under existing SEC rules, a fund is required to discuss in its

prospectus the principal risk factors associated with investing in the

fund.3 Funds typically describe the risks of investing in the fund

by describing the risks of particular investment policies that the fund

may use and investments that the fund may make.4 Lengthy and

highly technical descriptions of permissible policies and investments

that are often used in meeting existing requirements may make it

difficult for investors to understand the total risk level of a fund.

The SEC staff has found that funds typically provide only the most

general information on the risk level of the fund taken as a whole and

has encouraged funds to modify their existing disclosure to enhance

investor understanding of risks.5 The SEC believes that it is now

appropriate to explore whether SEC disclosure requirements should be

revised in order to improve the communication of fund risks to

investors and increase the likelihood that investors will readily grasp

the risks of investing in a particular fund before they invest.

\3\Risk factors include those peculiar to the fund and those

that apply generally to funds with similar investment policies and

objectives or, in the case of closed-end funds, similar capital

structures or trading markets. Item 4(c), Form N-1A, & Guide 21,

Disclosure of Risk Factors, Guidelines for Form N-1A [17 CFR 239.15A

& 274.11A] (mutual funds); Item 8.3.a., Form N-2 [17 CFR 239.14 &

274.11a-1] (closed-end funds).

\4\See Form N-1A, Item 4(a)(ii) (requires concise description of

mutual fund investment objectives and policies and brief discussion

of how the fund proposes to achieve such objectives, including

description of the securities in which the fund will invest and

special investment practices or techniques that will be employed);

Form N-1A, Item 4(b) (requires discussion of types of investments,

policies, and practices that will not constitute the ``principal

portfolio emphasis'' of a mutual fund, but which place more than 5%

of the fund's net assets at risk); Form N-2, Item 8.2. & 8.4.

(similar requirements for closed-end funds).

\5\See Memorandum dated Sept. 26, 1994, from Division of

Investment Management to Chairman Levitt regarding Mutual Funds and

Derivative Instruments 11 [hereinafter ``Derivatives Report''];

Letter to Registrants from Carolyn B. Lewis, Assistant Director,

Division of Investment Management 7 (Feb. 25, 1994) (both documents

on file with the SEC's Public Reference Room).

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Several factors make it important that the SEC explore better ways

of explaining fund risks to investors. First, average Americans are

placing increasing reliance on funds to meet important financial needs,

such as retirement and college expenses.6 Understanding the risks

of various investment products is one of the most important ingredients

in creating an overall investment strategy or portfolio to meet these

financial needs.7 Second, [[Page 17173]] new ways of describing

risks may improve investor understanding of the risks associated with

the use by some funds of increasingly complex instruments, such as

derivatives.8 Third, the number and types of funds have

proliferated, increasing fund investors' need for information that will

help them to compare and contrast alternatives.9

\6\According to a June 1994 survey sponsored by the Investment

Company Institute, 31% of United States households owned shares in a

mutual fund, up from 6% of households in 1980. Investment Company

Institute, Fundamentals (Sept. 1994); Investment Company Institute,

1994 Mutual Fund Fact Book 85 (34th ed. 1994) [hereinafter ``1994

ICI Fact Book'']. Mutual funds held 14.9% of all household

discretionary assets as of June 30, 1994, up from 7.0% at the end of

1982. Source: Investment Company Institute. Total mutual fund assets

have grown from $292.9 billion at the end of 1983 to $2.16 trillion

at the end of December 1994. 1994 ICI Fact Book, supra, at 26;

Investment Company Institute Press Release, ``December Mutual Fund

Sales Total $39.9 Billion,'' Jan. 26, 1995, at 4.

By the end of 1993, retirement assets accounted for 23% of

mutual fund assets (excluding variable annuities), and mutual funds

held almost $284 billion of the approximately $857 billion invested

in individual retirement accounts (``IRAs'')--about 33% of total IRA

assets. 1994 ICI Fact Book, supra, at 69.

\7\See, e.g., Burton G. Malkiel, A Random Walk Down Wall Street

ch. 13 (1990) [hereinafter ``Random Walk'']; Susan E. Kuhn, ``What

it Takes to Retire Today,'' Fortune, Dec. 26, 1994, at 113; Joshua

Shapiro, ``The Discipline of Saving for College,'' New York Times,

Sept. 10, 1994, at 34.

\8\See Testimony of Arthur Levitt, Chairman, U.S. Securities and

Exchange Commission, Concerning Issues Affecting the Mutual Fund

Industry, Before the Subcommittee on Telecommunications and Finance,

Committee on Energy and Commerce, U.S. House of Representatives 18-

19 (Sept. 27, 1994); Derivatives Report, supra note 5, at 11-12.

\9\See, e.g., 1994 ICI Fact Book, supra note 6, at 30-31

(increase from 564 mutual funds at the end of 1980 to 4,558 at the

end of 1993; mutual funds classified according to 21 investment

objectives).

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The importance of risk disclosure was underscored last year when

some short-term government bond funds experienced losses as interest

rates increased sharply.10 Shareholders in these funds expressed

surprise at the losses, and several shareholder lawsuits were

filed.11 Whatever the legal merits of the shareholder complaints

may be, the SEC believes that these events highlight the importance of

clear, concise disclosure of risks.

\10\See, e.g., Leslie Eaton, ``Paine Webber to Bail Out Fund

Battered by Complex Investments,'' New York Times, July 23, 1994, at

A1; Robert McGough, ``Piper Jaffray Acts to Boost Battered Fund,''

Wall Street Journal, May 23, 1994, at C1.

\11\See, e.g., Karen Donovan, ``Derivatives Slump; Losers Go to

Court,'' National Law Journal, Nov. 7, 1994, at A1; G. Bruce Knecht,

``Minneapolis Investors Are Hurt By Local Firm They Knew As

Cautious,'' Wall Street Journal, Aug. 26, 1994, at A1; John

Waggoner, ``Mutual Fund Losses Anger Novice Investors,'' USA Today,

June 16, 1994, at 1B.

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In this Release, the SEC requests that those submitting comments

discuss the specific goals of, and various alternatives for, improving

risk disclosure. Comments are requested on the relative merits of

written and other presentations of risk, including quantitative or

numerical measures, graphs, tables, and other pictorial

representations.

The Release describes and requests comment on several specific

quantitative measures of risk and risk-adjusted performance, including

standard deviation, semi-variance, beta, duration, the Sharpe Ratio,

the Treynor Ratio, and Jensen's Alpha. These measures of risk are

potentially useful because they may give investors a tool for balancing

the potential returns of a fund against the risks of the fund. For

instance, if a fund has historical annual returns which are 2% above a

market index, historical risk measures may provide some indication of

the risks that were taken to produce the increased returns.

Quantitative risk measurements may provide investors with tools to

measure how funds have fared historically in the relationship between

risk and return.

The Release also asks for comments addressing a number of general

topics related to quantitative risk measures. These include:

The benefits to be derived from quantitative measures

versus the costs and burdens to the fund that must produce such

information;

Quantitative measures currently used by fund managers to

assess risk, and whether such internally used measures should be

disclosed to investors;

Investor understanding of quantitative measures, and means

to increase that understanding;

Standardizing the ways in which funds calculate

quantitative measures to assure comparability and the validity of any

underlying assumptions; and

Availability of quantitative risk information from third

party providers (e.g., the financial press and rating services).

Comments are also requested on whether funds should be required to

disclose a self-assessment of their risk level, using an SEC-created

standard scale or some other method. In addition, comments are

requested on whether funds should describe to investors the ways or

strategies that fund managers use to manage, understand, and monitor

the risks of their funds.

The SEC requests comments that address the specific questions posed

in this Release as well as alternative risk disclosure methods and

related matters. Where possible, please provide actual rule language

that you believe would best express your recommendation.

To encourage individual investor comments and suggestions on this

Release, the SEC for the first time has prepared a short summary

specifically directed to individual investors. The summary, which

appears as an appendix to the Release, will be reprinted in a format

that leaves space for individual investors to tell the SEC about their

concerns and ideas and distributed through investor groups and other

means designed to reach individual investors.

I. The Goals of Risk Disclosure

The SEC's goal is to improve disclosure of fund risks so that

investors will have the information they need to understand the risk of

any particular fund investment. The best means for achieving this aim

may depend, in part, on the specific goals of risk disclosure. The SEC

therefore requests comment on the specific goals of risk disclosure,

including the matters raised below.

The SEC asks persons submitting comments to define, as precisely as

possible, what ``risks'' should be disclosed to investors. To what

extent are investors concerned with the likelihood that they will lose

principal, that their return will not exceed a specified benchmark

(such as the Standard & Poor's (``S&P'') 500), or with the variability

of their returns (or the volatility of the value of their investment)

over time? How should the relationship between risk and an investor's

time horizon shape the disclosure that is provided to investors? For

example, is the same risk information useful to an investor with an

investment time horizon of less than one year and to an investor with

an investment time horizon of twenty years?12 How can the

disclosure of risk help investors answer the fundamental questions--Is

this investment suitable for me? If I have diversified my investments,

how does this particular fund fit into my diversification strategy?

\12\See Letter to Barry P. Barbash, Director, Division of

Investment Management, from Paul Schott Stevens, General Counsel,

Investment Company Institute 3-4 (Jan. 19, 1995) [hereinafter ``ICI

Letter''] (on file with the SEC's Public Reference Room) (discussing

different concepts of risk); Paul A. Samuelson, ``The Long-Term Case

for Equities and How it Can be Oversold,'' Journal of Portfolio

Management 15-24 (Fall 1994) (raising questions about common wisdom

that, for long-term investor, stocks will outperform bonds or cash).

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Comments are requested on the nature of risk comparisons that are

useful to investors. For example, should risk disclosure facilitate

comparison among a broad range of investment options, such as between

funds and other investment products? Or is it sufficient to facilitate

comparisons among all funds and fund types, both equity and fixed

income? Or among all equity funds, on the one hand, and all fixed

income funds, on the other? Or only within groups of funds with similar

investment objectives and policies, such as short-term government bond

funds?

Is improved disclosure of risks equally important for equity, fixed

income, and balanced or asset allocation funds? Do recent derivatives-

related losses by some fixed income funds, and the apparently greater

use of derivatives by fixed income funds, suggest that the need for

improved disclosure of risks is greater for fixed income funds?13

In [[Page 17174]] light of the substantive limits on permitted money

market fund investments,14 should risk disclosure requirements for

money market funds be different from those applicable to other

funds?15

\13\See supra notes 10 and 11 and accompanying text. A recent

industry survey of non-money market funds indicated that the level

of derivatives use varied by fund type, with fixed income funds

accounting for 84% of the total market value of all derivatives held

by reporting funds and 62% of the total national amount. Investment

Company Institute, Derivative Securities Survey 6 (Feb. 1994).

Survey respondents included 52 fund complexes with 1,728 non-money

market funds holding aggregate net assets of $958 billion (76% of

industry assets in non-money market funds). Id. at 4.

\14\Mutual funds are prohibited from calling themselves money

market funds unless they comply with the risk-limiting provisions of

rule 2a-7 under the Investment Company Act. These provisions are

designed to limit a fund's exposure to credit, interest rate, and

currency risks. 17 CFR 270.2a-7(b), (c)(2)-(4), & (d).

\15\Losses in the value of certain adjustable rate notes held by

some money market funds recently resulted in the funds' advisers

electing to take actions designed to prevent the funds' per share

net asset values from falling below $1.00; and one small,

institutional money market fund liquidated and redeemed its shares

at less than $1.00 as a result of such losses. See, e.g., ``A

History of Stepping up to the Plate,'' Fund Action, Sept. 12, 1994,

at 9; Brett D. Fromson, ``Losses on Derivatives Lead Money Fund to

Liquidate,'' Washington Post, Sept. 28, 1994, at F1. These losses,

however, raise concerns about the appropriateness of the funds'

investments in some types of adjustable rate securities and not

merely risk disclosure concerns. See Revisions to Rules Regulating

Money Market Funds, Investment Company Act Rel. No. 19959,

Sec. II.D.2.d. (Dec. 17, 1993) [58 FR 68585, 68601-02 (Dec. 28,

1993)] [hereinafter ``Rel. 19959''] (certain types of adjustable

rate notes not appropriate investments for money market funds). See

also Letter from Barry P. Barbash, Director, Division of Investment

Management, to Paul Schott Stevens, General Counsel, Investment

Company Institute (June 30, 1994) (on file with the SEC's Public

Reference Room).

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Comments are also requested on the degree of detail regarding fund

risk that ideally would be communicated to investors. In meeting

existing disclosure requirements, funds often describe the purposes of

using particular types of instruments and the risks associated with

each type, but typically provide only the most general information on

the risk level of the fund taken as a whole.16 Should disclosure

convey the risks of each particular type of instrument held by a fund,

the risks of broader classes of instruments (for instance, derivatives

as a group), the risks of the fund's portfolio as a whole, or some

combination of the foregoing? Should the focus of disclosure be shifted

from the characteristics of particular securities to the nature of the

investment management services offered, including the objectives of a

fund manager and the associated risks and rewards? Do investors need to

understand separately the different types of risk, such as market,

credit, legal, and operational risks, or is it the aggregate effect of

different types of risk that is important to an investment decision?

\16\See Derivatives Report, supra note 5, at 11.

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II. Narrative and Non-Narrative Risk Disclosure Options

The SEC currently requires fund prospectuses to include narrative

descriptions of risk,17 and the SEC is interested in the potential

for improving risk disclosure through changes to the narrative

disclosure requirements and the use of non-narrative forms of

disclosure. The SEC therefore asks persons submitting comments to

discuss the contributions that both narrative and non-narrative forms

of disclosure can make to investor understanding of risk and to provide

the SEC with the findings of any relevant market research on the

effective communication of risk.

\17\See supra notes 3 and 4 and accompanying text.

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At present, a number of funds voluntarily supplement narrative

descriptions of risk through means such as quantitative measures,

graphs, tables, and other pictorial representations. For example, some

funds provide quantitative risk measures like those described in

section III.A. of this Release. Another method used is a line graph

that shows relative risk and return levels for the fund and some

benchmark, such as Treasury bills or a market index such as the S&P

500. Another method is a bar graph that shows consistency of returns

for the fund and a market index (as measured by monthly rates of return

over the life of the fund). Finally, some fund families use pictures to

show the relative risks of the various funds within the family.

The SEC believes that quantitative measures, graphs, tables, and

other pictorial representations may assist investors in understanding

and comparing funds. The SEC currently requires disclosure of

quantitative information in tabular form in the areas of fund

performance and expenses.18 Recently, the SEC adopted rules that

require graphic depictions of information to facilitate investor

understanding of fund performance.19 The SEC now requests comment

on the relative merits and usefulness of various formats for investment

company risk disclosure, including quantitative measures, graphs,

tables, and other pictorial representations. To what extent should

these methods be used to supplement, or replace, current narrative risk

disclosure?

\18\For mutual funds, see Form N-1A, Items 2 (Synopsis), 3

(Condensed Financial Information), and 5A (Management's Discussion

of Fund Performance). For closed-end funds, see Form N-2, Items 3

(Fee Table and Synopsis) and 4 (Financial Highlights). See also

supra note 1 and accompanying text. A closed-end fund is also

required to include in its prospectus a table quantifying the

effects of leverage on returns to investors. Form N-2, Item

8.3.b.(3) (General Description of the Registrant, Risk Factors,

Effects of Leverage).

\19\See supra note 1. The SEC also recently adopted rules

requiring graphic depictions of issuer performance by public

companies that are not investment companies. Executive Compensation

Disclosure, Securities Exchange Act Rel. No. 31327 (Oct. 16, 1992)

[57 FR 48126 (Oct. 21, 1992)].

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III. Quantitative Measures of Risk

A. Specific Historical Quantitative Measures of Risk and Risk-Adjusted

Performance

This section of the Release discusses several historical

quantitative measures of risk and risk-adjusted performance that could

be used for fund disclosure, and the following section raises a number

of general questions about quantitative measures. Comments are

requested regarding whether the SEC should require fund disclosure of

any one or a combination of the enumerated measures or any other

measures. Persons submitting comments are also asked to consider each

of the enumerated quantitative measures, and any other measures they

may wish to suggest, in the context of the general questions raised in

the following section.

Historical measures of risk and risk-adjusted performance are

generally calculated from past portfolio returns and, in some cases,

past market returns. There are two broad classes of historical risk

measures, referred to in this Release as total risk measures and market

risk measures. In addition, there is a third class of measures, risk-

adjusted measures of performance. (Unless the context indicates

otherwise, risk-adjusted measures of performance are included in

``quantitative risk measures'' and similar terms and phrases used in

this Release.) These three classes of measures are described below, and

examples of each are provided. Comments are requested on the relative

advantages and disadvantages of the three classes of measures and of

specific measures within each class.

1. Measures of Total Risk

Total risk measures, including standard deviation and semi-

variance, quantify the total variability of a portfolio's returns

around, or below, its average return.

Standard Deviation of Total Return. The risk associated

with a portfolio can be viewed as the volatility of its returns,

measured by the standard deviation of those returns.20 For

example, a fund's [[Page 17175]] historical risk could be measured by

computing the standard deviation of its monthly total returns over some

prior period, such as the past three years. The larger the standard

deviation of monthly total returns, the more volatile, i.e., spread out

around the fund's average monthly total return, the fund's monthly

total returns have been over the prior period. Standard deviation of

total return can be calculated for funds with different objectives,

ranging from equity funds to fixed income funds to balanced funds, and

can be measured over different time frames. For example, a fund could

calculate standard deviation of monthly returns over the prior three

years or yearly returns over the prior ten years.

\20\William F. Sharpe, Gordon J. Alexander, and Jeffery V.

Bailey, Investments 178 (5th ed. 1995) [hereinafter ``Sharpe,

Alexander, & Bailey'']. If the returns earned by a portfolio are

``normally'' distributed, that is, in the shape of a bell curve,

approximately 95% of the actual returns will fall within two

standard deviations of the average return. Random Walk, supra note

7, at 219. For example, for a fund with an average monthly return of

1% and a standard deviation of 4%, 95% of the fund's monthly returns

would fall between -7% (1%-(2 x 4%)) and 9% (1%+(2 x 4%)) if the

returns were ``normally'' distributed. See Sharpe, Alexander, &

Bailey, supra, at 177.

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Semi-variance. Standard deviation measures both ``good''

and ``bad'' outcomes, i.e., the variability of returns both above and

below the average return. To the individual investor, however, risk may

be synonymous with ``bad'' outcomes.21 Semi-variance, which can be

used to measure the variability of returns below the average return,

reflects this view of risk.22 A fund with a larger semi-variance

has returns that are more spread out below the average return.

\21\See Sharpe, Alexander, & Bailey, supra note 20, at 178;

Allan Flader, ``Deviating from the Standard,'' Financial Planning,

June 1994, at 148.

\22\Funds' risk levels would be ranked in the same order using

semi-variance and standard deviation if the distribution of fund

returns were symmetric. Sharpe, Alexander, & Bailey, supra note 20,

at 178.

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2. Measures of Market Risk

Individual securities, and portfolios of securities, are generally

subject to two sources of risk: (i) Risk attributable to firm-specific

factors, including research and development, marketing, and quality of

management; and (ii) risk attributable to general economic conditions,

including the inflation rate, interest rates, and exchange

rates.23 According to academic literature in Finance, firm-

specific risk can be reduced or eliminated through portfolio

diversification, but the risk attributable to general economic

conditions, so-called ``market risk,'' cannot be eliminated through

diversification.24 Unlike standard deviation and variance, which

measure portfolio risk from both sources, the measures described in

this section are measures of market risk. The SEC requests comment on

whether, given that most fund portfolios are diversified, it is

appropriate to focus on market risk when measuring fund risks.

\23\Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments 197

(2d ed. 1993) [hereinafter ``Bodie, Kane, & Marcus''].

\24\Bodie, Kane, & Marcus, supra note 23, at 197-99; Sharpe,

Alexander, & Bailey, supra note 20, at 212-17.

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Beta. Beta measures the sensitivity of a security's, or

portfolio's, return to the market's return. The market's beta is by

definition equal to 1. Portfolios with betas greater than 1 are more

volatile than the market, and portfolios with betas less than 1 are

less volatile than the market. For example, if a portfolio has a beta

of 2, a 10% market return would result in a 20% portfolio return, and a

10% market loss would result in a 20% portfolio loss (excluding the

effects of any firm-specific risk that has not been eliminated through

diversification).25

\25\Sharpe, Alexander, & Bailey, supra note 20, at 211; Frank J.

Fabozzi and Franco Modigliani, Capital Markets: Institutions and

Instruments 136-40 (1992) [hereinafter ``Fabozzi & Modigliani''].

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The calculation of a fund's historical beta requires the selection

of a benchmark market index, and persons supporting the use of beta are

asked to address how the benchmark should be selected and whether a

single benchmark should be used for all funds. If a single benchmark

should be selected, what should it be? If a single benchmark is not

used, how should the lack of comparability of betas for funds using

different benchmarks be addressed? Beta is generally used in connection

with equity securities, and persons submitting comments are asked to

address whether or not the use of beta should be limited to equity

funds.

Duration.26 Duration is a measure of the price

sensitivity of a bond, or bond portfolio, to interest rate

changes.27 There are different types of duration,28 and

persons supporting the use of duration are asked to be specific

regarding the duration measure that they support. Would so-called

``modified duration,'' which can be interpreted as the percentage

change in the price of a bond, or bond portfolio, for a 100 basis point

change in yield, be particularly useful?29

\26\The SEC previously requested comment on duration as a

measure of interest rate risk for securities held by money market

funds. See Rel. 19959, supra note 15, Sec. II.D.2.d., 58 FR at

68602. In response to that request, several persons submitting

comments expressed support for the use of duration or other price

volatility tests; one person specifically opposed a duration

requirement on the grounds that the costs funds would incur would

outweigh benefits to investors. See Summary of Comment Letters on

Proposed Amendments to Rules Regulating Money Market Funds Made in

Response to Investment Company Act Rel. 19959, File No. S7-34-93,

Nov. 10, 1994, at 63-64.

\27\Bodie, Kane, & Marcus, supra note 23, at 473-74. Duration

measures the weighted average maturity of a bond's, or bond

portfolio's, cash flows, i.e., principal and interest payments. A

zero-coupon bond's duration, for example, is the same as its

maturity because its sole cash flow is the payment made at maturity.

By contrast, a bond bearing interest payable periodically has a

duration that is shorter than its maturity because the periodic

interest payments reduce the weighted average maturity of the bond's

cash flows below the final maturity of the bond. Id.

\28\For a discussion of the computation and interpretation of

so-called ``Macaulay duration'' and ``modified duration,'' see

Bodie, Kane, & Marcus, supra note 23, at 473-75, and Fabozzi &

Modigliani, supra note 25, at 393-98.

\29\Fabozzi & Modigliani, supra note 25, at 397. For example, if

a bond portfolio has a modified duration of 7 and yield increases by

100 basis points, the estimated decrease in the value of the

portfolio would be 7%.

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The use of duration has several limitations, and persons submitting

comments are asked to address each of these. First, duration is only

meaningful for bonds and portfolios of bonds and therefore cannot be

used to measure the risk of equity funds and has limited applicability

to balanced funds. Second, duration measures interest rate risk only

and not other risks to which bonds are subject, e.g., credit risks and,

in the case of non-dollar denominated bonds, currency risks. Third,

duration is difficult to calculate precisely for bonds with prepayment

options, e.g., mortgage-backed securities, because the calculation

requires assumptions about prepayment rates.30 Fourth, bond value

changes resulting from interest rate changes are sometimes poorly

predicted by duration.31

\30\See James Hom and Gary Arne, Standard & Poor's,

``Prepayments and Model Error in Fund Risk Ratings,'' CreditReview,

Jan. 16, 1995, at 17-18; John Rekenthaler, Commentary: ``Duration

Arrives,'' Morningstar Mutual Funds, Jan. 21, 1994, at 1-2.

\31\Duration is less useful as a measure of interest rate risk

when the following conditions are not met: (1) the yield curve is

flat (i.e., interest rates for all maturities of bonds are the

same), (2) changes in yield are small, and (3) yield shifts are

parallel (i.e., the Treasury yields of all maturities change by

equal numbers of basis points). See Fabozzi & Modigliani, supra note

25, at 396-401.

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The SEC staff takes the position that, for a fund with a name or

investment objective that refers to the maturity of the fund's

portfolio, such as ``short-term'' or ``long-term,'' the dollar-weighted

average portfolio maturity of the portfolio must reflect that

characterization.32 The SEC requests [[Page 17176]] comment on

whether, separate and apart from duration's potential use as a

quantitative risk measure, a fund's name or investment objective that

refers to the maturity of its portfolio should be required to be

consistent with the fund's duration.

\32\See, e.g., Form N-7 for Registration of Unit Investment

Trusts Under the Securities Act of 1933 and the Investment Company

Act of 1940, Investment Company Act Rel. No. 15612 (Mar. 9, 1987)

[52 FR 8268, 8301 (Mar. 17, 1987)] (guide to proposed registration

form for unit investment trusts publishing staff position on

portfolio maturity).

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3. Risk-Adjusted Measures of Performance33

\33\The SEC has solicited comment on risk-adjusted measures of

performance on two prior occasions. In 1990, the SEC requested

comment on whether mutual funds should be required to adjust

performance figures to reflect risk for purposes of Item 5A of Form

N-1A. See Disclosure and Analysis of Mutual Fund Performance

Information; Portfolio Manager Disclosure, Investment Company Act

Rel. No. 17294 (Jan. 8, 1990) [55 FR 1460, 1464 (Jan. 16, 1990)].

See also Summary of Comments on Proposed Amendments to Form N-1A,

File S7-1-90, at 23-24 (summarizing views of the nine persons

submitting comments who addressed risk adjustment of performance,

all of whom opposed it).

In 1986, the SEC requested comment on how mutual funds could

present risk-adjusted performance information in advertisements

prepared in accordance with rule 482 under the Securities Act of

1933 [17 CFR 230.482]. See Advertising by Investment Companies;

Proposed Rules and Amendments to Rules, Forms, and Guidelines,

Investment Company Act Rel. No. 15315 (Sept. 17, 1986) [51 FR 34384,

34390 (Sept. 26, 1986)]. See also Summary of Comments on Mutual Fund

Advertising Proposals, File No. S7-23-86, Mar. 31, 1987, at 69-70

(summarizing views of the thirteen persons submitting comments who

addressed the issue, including nine who supported it and one who

opposed it).

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Risk-adjusted measures of performance were developed in the 1960s

to compare the quality of investment management. Three widely-used

risk-adjusted measures are:

Sharpe Ratio.34 Also known as the Reward-to-

Variability Ratio, this is the ratio of a fund's average return in

excess of the risk-free rate of return (``average excess

return'')35 to the standard deviation of the fund's excess

returns. It measures the returns earned in excess of those that could

have been earned on a riskless investment per unit of total risk

assumed.

\34\See William F. Sharpe, ``The Sharpe Ratio,'' 21 Journal of

Portfolio Management 49-58 (Fall 1994); William F. Sharpe, ``Mutual

Fund Performance,'' 39 Journal of Business 119-38 (Jan. 1966);

Sharpe, Alexander, & Bailey, supra note 20, at 935-37; Edwin J.

Elton & Martin J. Gruber, Modern Portfolio Theory and Investment

Analysis 648-52 (4th ed. 1991) [hereinafter ``Elton & Gruber''].

\35\The yield on 90-day Treasury bills is often used as a proxy

for the risk-free rate of return.

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Treynor Ratio.36 Also known as the Reward-to-

Volatility Ratio, this is the ratio of a fund's average excess return

to the fund's beta. It measures the returns earned in excess of those

that could have been earned on a riskless investment per unit of market

risk assumed. Unlike the Sharpe Ratio, the Treynor Ratio uses market

risk (beta), rather than total risk (standard deviation), as the

measure of risk.

\36\See Jack L. Treynor, ``How to Rate Management of Investment

Funds,'' 43 Harvard Business Review 63-75 (Jan.-Feb. 1965); Sharpe,

Alexander, & Bailey, supra note 20, at 934-35; Elton & Gruber, supra

note 34, at 657-58.

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Jensen's Alpha.37 This is the difference between a

fund's actual returns and those that could have been earned on a

benchmark portfolio with the same amount of market risk, i.e., the same

beta, as the portfolio.38 Jensen's Alpha measures the ability of

active management to increase returns above those that are purely a

reward for bearing market risk.

\37\Michael C. Jensen, ``The Performance of Mutual Funds in the

Period 1945-1964,'' 23 Journal of Finance 389-416 (May 1968);

Michael C. Jensen, ``Risk, the Pricing of Capital Assets, and the

Evaluation of Investment Portfolios,'' Journal of Business (Apr.

1969); Sharpe, Alexander, & Bailey, supra note 20, at 927-34.

\38\For an equity fund, the benchmark portfolio could be

comprised of a market index, e.g., the S&P 500, and a risk-free

asset, e.g., 90-day Treasury bills. Sharpe, Alexander, & Bailey,

supra note 20, at 798.

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B. General Issues

This section of the Release raises a number of general questions

about quantitative risk measures. Persons submitting comments are asked

to address these questions, particularly in the context of specific

quantitative measures.

1. Benefits of Quantitative Risk Measures

The SEC asks for comments on the potential benefits that could be

derived from fund disclosure of quantitative risk measures. Comments

are also requested on associated costs and burdens.

Would quantitative risk measures, including risk-adjusted measures

of performance, help investors to evaluate historical performance and

investment management expertise? The SEC requires that fund

prospectuses include standardized return information,39 even

though past returns are not necessarily indicative of future returns.

Persons submitting comments are asked to address whether quantitative

disclosure of the risk level incurred to produce stated returns may

provide investors with a better tool to understand past fund

performance and management.40 Historical data could, for example,

help investors distinguish among funds that have achieved comparable

rates of return with significantly different levels of risk. Would it

be helpful to investors for funds to present one or more risk measures

together with fund performance data in the financial highlights

table?41 Would a risk measure that covers the same periods

currently required for reporting total returns in the financial

highlights table in fund prospectuses or in mutual fund advertisements

be useful to investors?42

\39\Form N-1A, Item 3; Form N-2, Item 4.

\40\For discussions of the importance of risk as a component of

performance evaluation, see Sharpe, Alexander, & Bailey, supra note

20, at 917-49, and Bodie, Kane, & Marcus, supra note 23, at 796-826.

Funds are currently required to disclose historical returns for

each of the last ten fiscal years (or, if less, the life of the

fund). See Form N-1A, Item 3. This data shows variability of past

annual returns and therefore provides some guidance regarding past

risk.

\41\See Form N-1A, Item 3; Form N-2, Item 4 (financial

highlights table).

\42\See Form N-1A, Item 3 & Form N-2, Item 4 (fund financial

highlights tables cover each of last ten fiscal years); rule 34b-1

under the Investment Company Act [17 CFR 270.34b-1] & rule 482(e)(3)

under the Securities Act [17 CFR 230.482(e)(3)] (non-money market

mutual fund advertisements and sales literature containing

performance information required to contain average annual total

return for one, five, and ten years).

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Would quantitative risk measures be useful to investors as

indicators or guides to future fund risk levels, enhancing investors'

ability to compare risks assumed by investing in different funds? The

SEC requests any research related to the degree of correlation between

historical measures of a fund's risk and expected future levels of

risk.

2. Risk Measures Currently Used by Investment Companies

The SEC requests comment on whether quantitative risk measures that

are currently used by investment companies for internal purposes, such

as portfolio management, evaluation or compensation of portfolio

managers, and reports by management to the board of directors, could be

adapted for disclosure purposes. This approach could have two potential

advantages: first, the measures currently used by investment companies

presumably have been determined to be the most useful by fund managers,

who are in the best position to understand and analyze fund risk; and,

second, use of these measures for disclosure purposes should impose

relatively small additional costs on funds. The SEC therefore requests

that persons submitting comments identify which quantitative risk

measures funds use internally and for what purposes.

The SEC also asks persons submitting comments to discuss the extent

to which quantitative risk measures used by investment companies for

internal purposes would be useful to investors. If such measures would

not be useful to investors, why not? How might internal measures be

adapted to avoid or overcome these problems?

3. Investor Understanding of Quantitative Risk Measures

Persons submitting comments are asked to discuss the difficulties

that [[Page 17177]] investors would face in properly interpreting

various quantitative risk measures, such as understanding what aspects

of risk are measured, the limits on predictive utility of risk

measures, and the importance of investment time horizon in determining

how much risk to assume. Are the difficulties significantly greater

than those associated with the proper interpretation of yield and

return figures? Is there a potential problem of investor over-reliance

on quantitative risk measures, and, if so, what could be done to

protect against such over-reliance?

Comments are also requested regarding which quantitative risk

measures would be easiest for investors to use properly and how

quantitative measures can be made more understandable to investors. One

possibility is to provide some form of interpretation of raw numbers.

For example, standard deviations could be divided by the standard

deviation for some benchmark such as the S&P 500. Another possibility

is to convert raw numbers into a classification scale, such as one to

ten or ``very low'' to ``very high'' risk. Another possibility would be

to represent the level of fund volatility graphically, rather than

through computation of standard deviation. Would it be helpful, for

example, if funds were required to include a bar graph showing total

returns for each of the last 10 years to provide investors a picture of

the extent to which annual returns varied over that period and the

frequency with which the returns were negative or below some benchmark?

Would a chart like the following be helpful?

Using historical numbers, the following illustrates the fund's

estimated variability of quarterly returns over the noted periods

(i.e., approximately 95% of the time, the fund's quarterly returns fell

within these ranges).

------------------------------------------------------------------------

10 year 5-year 3-year

------------------------------------------------------------------------

-5% to 9%............... -4% to 8%............... -5% to 8%.

------------------------------------------------------------------------

Are there narrative disclosures that can help investors to

understand risk measures? Persons submitting comments are asked to

report the results of any experience with, or research on, the relative

effectiveness of alternative means of presenting quantitative

information.

4. Historical Measures v. Portfolio-Based Measures v. Risk Objectives

or Targets

There are three approaches to the use of quantitative risk

measures: historical, portfolio-based, and risk objectives or targets.

The SEC asks for comments on the relative merits and limitations of

these three approaches.

The simple historical approach to quantitative risk measures is

outlined in section III.A., above. This method generally uses actual

past returns of a fund to compute a measure of risk for the fund. An

alternative is a portfolio-based computation, which calculates a

portfolio risk measure based on the particular securities in the

portfolio as of a specified measurement date.43 This method, too,

is historical in that the computation (i) uses the portfolio

composition as of a specified measurement date, and (ii) the

computation is based on historical behavior of the securities in the

portfolio.

\43\See, e.g., Comptroller of the Currency, Risk Management of

Financial Derivatives 49-53 (Oct. 1994); J.P. Morgan, Introduction

to RiskMetricsTM (2d ed.) (Oct. 25, 1994); Group of Thirty,

Derivatives: Practices and Principles 10-11 (July 1993).

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There are at least two important limitations of using portfolio-

based measures for fund disclosure: first, a fund may be invested in

newly introduced financial instruments that have little or no history,

and for which historical behavior must be estimated, and, second,

portfolio-based measures, which are derived from portfolio composition

on one particular date, may be less representative of the risk of a

managed portfolio over time than a simple historical measure derived

from fund returns over a period of time.

The SEC seeks comment on whether the SEC should require funds

generally to disclose portfolio-based risk measures.44 The SEC

also asks for comments on whether such measures could be useful for new

funds that do not have sufficient operating history to make use of a

simple historical measure meaningful, funds that change their

investment objectives or policies, funds that change investment

advisers or portfolio managers, or merged funds comprised of different

funds with different operating histories and different past risk

levels.45

\44\The Investment Company Institute has suggested that

portfolio-based measures would be of limited relevance at best in an

actively managed portfolio, would ignore the role of portfolio

management, and would be burdensome to compute. ICI Letter, supra

note 12, at 8 n.10.

\45\Issues have arisen with respect to fund advertisement of

performance information in similar circumstances. See IDS Financial

Corp. (pub. avail. Dec. 19, 1994) (acquisition of other funds'

assets); North American Security Trust (pub. avail. Aug. 5, 1994)

(combination of two funds); The Managers Core Trust (pub. avail.

Jan. 28, 1993) (newly formed hub fund); Unified Funds (pub. avail.

Apr. 23, 1991) (changed investment adviser); John Hancock Asset

Allocation Trust (pub. avail. Jan. 3, 1991) (change from money

market fund to asset allocation fund); Founders Funds, Inc. (pub.

avail. Oct. 15, 1990) (change from unit investment trust to mutual

fund); Zweig Series Trust (pub. avail. Jan. 10, 1990) (changed

investment adviser); Philadelphia Fund, Inc. (pub. avail. Oct. 17,

1989) (changed investment adviser); Commonwealth Funds (pub. avail.

June 14, 1989) (combination of two funds); Investment Trust of

Boston Funds (pub. avail. Apr. 13, 1989) (changed investment

adviser); The Fairmont Fund Trust (pub. avail. Dec. 9, 1988)

(changed investment objective); and Growth Stock Outlook Trust, Inc.

(pub. avail. Apr. 15, 1986) (new fund).

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Another approach to risk measures is requiring funds to announce

risk objectives or targets. Any of the risk and risk-adjusted

performance measures could be used by funds in this manner. For

example, a fund could announce its intention to follow a strategy that

would yield a standard deviation of 10%-12% per year, a beta of 1.50-

1.75 with respect to the S&P 500, or a duration of 7-9 years. Comments

are requested regarding the relative merits of this approach as

compared to the simple historical and portfolio-based approaches.

Persons submitting comments are asked to address specifically the

relative merits for funds with significant operating histories, new

funds, funds that change their investment objectives or policies, funds

that change investment advisers or portfolio managers, or merged funds

comprised of different funds with different operating histories and

different past risk levels. Persons supporting the use of simple

historical measures by relatively new funds, funds that change their

investment objectives or policies or their investment advisers or

portfolio managers, or merged funds are also asked to address whether

narrative disclosure should be required to explain the limits on the

usefulness of the disclosure resulting from the funds' circumstances.

5. Computation Issues

Comments are requested on the following issues related to

computation of quantitative risk measures and on any other relevant

computation issues. What length of fund operating history is required

to make particular historical risk measures useful? What requirements

should be imposed on funds without this operating history? For example,

if 18 months of operations are required to calculate a meaningful

standard deviation figure, should funds that have been operating for

less than 18 months be required to disclose the standard deviation of

an appropriate market index or peer group of funds and explain any

differences they expect between the fund's standard deviation and that

of the index or peer group? [[Page 17178]]

For risk measures that require the use of a benchmark market index,

what issues, if any, are associated with the selection of an

appropriate benchmark? How should the SEC address the need to use

assumptions to calculate certain risk measures, such as the prepayment

assumptions that may be required to calculate duration? Can various

quantitative risk measures be manipulated and how do the various

measures differ in their susceptibility to manipulation? How can the

potential for such manipulation be reduced or eliminated? For instance,

is there some combination of risk measures the SEC could require that

would not be susceptible to simultaneous manipulation?

Persons submitting comments are also asked to describe as

specifically as possible the computation method they would recommend

for any quantitative risk measure they favor. For example, persons

favoring standard deviation should specify whether monthly returns,

quarterly returns, or returns over some other periods should be used.

As another example, persons favoring beta should describe the benchmark

or benchmarks that should be used. Persons submitting comments are also

asked to discuss the benefits and limitations associated with their

recommended method of computation.

6. Effects on Portfolio Management

The SEC recognizes that requiring disclosure of a quantitative risk

measure may affect portfolio management, e.g., causing fund managers to

adopt more conservative investment strategies. Comments are requested

regarding whether, and how, disclosure of a quantitative risk measure

might influence portfolio management and evaluating the associated

benefits and detriments.

7. Third Party Providers of Quantitative Risk Information

The financial press and other third parties currently disseminate

some quantitative information regarding fund risks. The available

information includes measures such as those described in section

III.A., including standard deviation, beta, and duration.46 In

addition, some organizations disseminate fund performance ratings that

take risk into account47 or fund risk ratings.48 This data is

made available either through reports and other documents published by

the organizations that collect and calculate the measures or through

periodicals and newspapers covering financial issues.

\46\See, e.g., CDA/Wiesenberger, Mutual Funds Update, Dec. 31,

1994; Morningstar Mutual Funds, Dec. 9, 1994; The Value Line Mutual

Fund Survey, Part 2, Ratings & Reports, Feb. 21, 1995. Value Line

also ranks mutual funds in five risk categories, based on historical

standard deviation. How to Use The Value Line Mutual Fund Survey, A

Subscriber's Guide (1994), at 4-5.

\47\See, e.g., Business Week, Feb. 14, 1994, at 78-79; Forbes,

Aug. 29, 1994, at 174; CDA/Wiesenberger, Investment Companies

Yearbook 1994 441 (1994); Morningstar Mutual Fund Performance

Report, Jan. 1995, at 3; How to Use The Value Line Mutual Fund

Survey, A Subscriber's Guide (1994), at 4-5.

\48\These ratings are based on an analysis of factors such as

currency, interest rate, liquidity, and mortgage prepayment risks;

hedging; leverage; and the use of derivatives. See ``Bond Fund Risks

Revealed,'' Fitch Research Special Report, Oct. 17, 1994, at 1; Gary

Arne, Standard & Poor's, CreditReview, Jan. 16, 1995, at 12.

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The SEC asks persons submitting comments to address the SEC's role

with respect to disclosure of quantitative risk information in light of

the availability of fund risk information from the financial press and

other third parties. Is there, for example, helpful risk information

that third party providers do not make available? Would SEC-required

disclosure be important to ensure that all investors have access to

some quantitative risk information and to help educate investors about

the importance of such information? Would SEC-required disclosure be

important to facilitate comparability among funds by ensuring that

standardized quantitative risk information will be available for all

funds? Would SEC-required disclosure of a quantitative risk measure be

helpful wherever historic returns are reported to indicate to investors

the risks incurred to generate those returns?

Persons submitting comments are also asked to address whether the

SEC should take any steps to facilitate the provision of fund risk

information by the financial press and other third parties. For

example, should the SEC require more frequent disclosure of fund

portfolio holdings or more detailed descriptions of fund portfolio

holdings to facilitate third party risk analyses? If so, what

information should the SEC require funds to make available and with

what frequency? The SEC is currently authorized to require funds to

file with the SEC ``such information * * * as the SEC may require, on a

semi-annual or quarterly basis, to keep reasonably current the

information and documents contained in the [funds' Investment Company

Act of 1940] registration statement[s] * * *.''49 Persons

submitting comments are asked to address whether statutory amendments

would be required to implement any recommendations they make in

response to this paragraph.

\49\Investment Company Act Sec. 30(b) [15 U.S.C. 80a-29(b)].

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Last year, the SEC requested comment regarding whether it should

encourage or require disclosure of third party fund risk ratings in

prospectuses, sales literature, and advertisements.50 Persons who

wish to address that issue in the context of today's broad inquiry into

improved risk disclosure are invited to do so.

\50\Nationally Recognized Statistical Rating Organizations,

Securities Act Rel. No. 7085 (Aug. 31, 1994) [59 FR 46314 (Sept. 7,

1994)]. The SEC is currently studying the comment letters received.

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IV. Narrative Disclosure Options

The SEC asks for comment on the usefulness to investors of

narrative risk disclosure currently found in prospectuses.51 The

SEC also asks persons submitting comments to describe ways of improving

narrative risk disclosure that will not increase, and may reduce,

technical information that may be of limited utility to investors. For

example, should prospectus disclosure focus on the broad investment

strategies of a fund rather than the particular investments used to

implement the strategy?

\51\See discussion supra notes 3-5 and accompanying text.

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Can disclosure of fund risks be improved through increased focus on

the policies and investments actually used by a fund as opposed to all

permissible policies and investments? For example, should a fund

describe the policies and investments that have been used during some

prior period, such as the preceding year, or that the fund intends to

use during some future period, such as the following year, and simply

list the other permitted policies and investments? Or should funds be

required to provide a table or grid that indicates whether, and the

extent to which, the policies and investments authorized to be used

were used during some prior period, such as the preceding year? If a

fund intends to alter the mix of policies and investments, should it be

required to describe the projected change? In addressing the questions

of this paragraph, persons submitting comments should consider the

possibilities of placing various information in the prospectus,52

annual [[Page 17179]] report, and statement of additional information.

For example, should the prospectus focus on the policies and

investments the fund has actually made and that it may make in the

reasonably foreseeable future, with the complete list of permissible

investments and policies to be disclosed in the statement of additional

information? As another example, should periodic reports be enhanced to

include more information about what policies and investments the fund

has, in fact, pursued and what risks were actually taken?

\52\Mutual funds generally offer their shares on a continuous

basis and, as a result, are required to file periodic ``post-

effective'' amendments to their registration statements in order to

maintain a ``current'' prospectus required by section 10(a)(3) of

the Securities Act [15 U.S.C. 77j(a)(3)]. Post-effective amendments

also satisfy the requirement that mutual funds amend their

Investment Company Act registration statements annually [17 CFR

270.8b-16]. Because closed-end funds do not generally offer their

shares to the public on a continuous basis, they generally do not

update their prospectuses periodically.

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Can risks be accurately depicted through narrative disclosure apart

from technical descriptions of particular types of investments? Would

investors find it useful for funds to provide in their prospectuses a

summary of the risk characteristics of the portfolio as a whole either

in lieu of or in addition to disclosure of the characteristics of

particular types of permissible investments? If a risk summary would be

useful, what risks should it address? For example, should the SEC

require a fund that invests a specified level, e.g., 5% or 10% or 25%,

of its net assets in a particular manner, e.g., securities of non-U.S.

companies, to discuss the related risks, e.g., exchange rate

fluctuations?53

\53\Cf. Form N-1A, Item 4(b)(ii) (greater prospectus disclosure

required for investment practices that place more than 5% of a

fund's net assets at risk).

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A mutual fund's Management's Discussion of Fund Performance

(``Management's Discussion''), contained in the prospectus or annual

report, is currently required to discuss the factors, including the

market conditions and the investment techniques and strategies, that

materially affected the fund's performance during the previous fiscal

year.54 The SEC requests comments regarding whether narrative risk

disclosure can be improved through amendments to the requirements for

the Management's Discussion. Should the SEC, for example, explicitly

require the Management's Discussion to address the risks assumed during

the previous fiscal year and the effects of those risks on fund

performance? Should the requirement for the Management's Discussion be

extended to money market funds? If the Management's Discussion is a

useful vehicle for risk disclosure, how should disclosure be

accomplished for closed-end funds, which are not subject to the

Management's Discussion requirements?

\54\Form N-1A, Item 5A.

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V. Self-Assessment of Risk

Another alternative upon which the SEC seeks comment is self-

assessment by funds of their aggregate risk level. One approach might

be to describe where the fund fits on a risk scale from low risk, for

instance, a money market fund, to moderate risk, for instance, a growth

and income fund investing in S&P 500 stocks and high quality bonds, to

high risk, for instance, an emerging market fund.55 Some fund

complexes currently place various funds within the complex on a risk

scale, and the SEC requests comment on whether such an approach would

be useful for comparing funds from different complexes. If risk self-

assessment is used, should the SEC create a standard scale? Persons

supporting an SEC-created scale are asked to describe specifically what

that scale should be, with particular attention to designing the scale

to promote a high degree of uniformity in funds' self-assessments.

Persons who favor a self-assessment approach but not an SEC-created

scale are asked to address how the approach will foster meaningful

investor comparisons among funds.

\55\In Rel. 19342, supra note 2, the SEC requested comment on

this approach and other formats for disclosing risk, including

numerical scales and other visual or symbolic representations. A

limited number of persons submitting comments addressed these

specific methods for standardizing risk disclosure. Summary of

Comments: Rel. 19342, supra, note 2, at 17-18.

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Comments are also requested on whether funds should be required to

provide self-assessments of their exposures to various types of risk,

with the results presented in chart or table format. Bond funds, for

example, might rate their interest rate risk, credit risk, prepayment

risk, and currency risk on a scale of low to medium to high.

VI. Risk Management Procedures

The disclosure options described in this Release have focused on

improved disclosure of the level of risk incurred by a fund. Persons

submitting comments are also asked to consider whether disclosure of

fund risk management procedures should be required. Such disclosure

could be narrative. For example, should funds be required to disclose

the extent and nature of involvement by the board of directors in the

risk management process? As another example, should funds describe the

``stress-testing'' they do to determine how the portfolio will behave

in various market conditions? Alternately, such disclosure could be

quantitative in format. For example, if the SEC requires disclosure of

a quantitative risk objective or target, funds could be required to

disclose the funds' actual risk level in subsequent periods and compare

it with the previously-provided objective or target and explain the

reasons for divergence.

VII. Liability Issues

Persons submitting comments are asked to address the appropriate

scope of, and limits on, the liability of funds, investment advisers,

and others for various risk disclosures. Persons submitting comments

should specify any forms of risk disclosure that they believe raise

particularly significant liability concerns, explain the concerns, and

suggest means for mitigating the concerns.

VIII. Regulatory Flexibility Act

According to the SEC's rules and unless otherwise defined for a

particular rulemaking proceeding, an investment company with net assets

of $50 million or less at the end of its most recent fiscal year is a

``small entity'' for purposes of the Regulatory Flexibility Act.56

The SEC requests persons submitting comments to describe and project

fund costs to provide the various disclosures described in this

Release, and any other disclosure that persons submitting comments may

wish to discuss, and address whether requiring the disclosure would

have a significant economic impact on small entities. If so, the SEC

asks persons submitting comments to describe that impact specifically.

Persons submitting comments also are asked to suggest methods for

improving disclosure of fund risks without imposing significant costs

on funds, specifically without having a significant economic impact on

funds that are small entities.

\56\Investment Company Act rule 0-10 [17 CFR 270.0-10].

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IX. Conclusion

The SEC is seeking comments and suggestions on a number of specific

issues related to fund disclosure of risks. Persons submitting comments

are encouraged, however, to address any other matters that they believe

merit examination.

Dated: March 29, 1995.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

Appendix--SEC Request for Investor Suggestions on How To Improve

the Descriptions of Risk in Mutual Funds

The U.S. Securities and Exchange Commission (``the SEC''), the

federal government agency that oversees mutual funds, wants to hear

from investors on [[Page 17180]] how the descriptions of risk in mutual

funds may be improved. When investors choose a mutual fund, they should

understand the risks of the fund before they invest and not be

surprised if the value of their investment rises and falls

significantly.

The risks and potential rewards of investing in any mutual fund are

explained in a written document provided by the mutual fund called a

``prospectus.'' The prospectus contains information that is important

to making an informed decision when choosing a mutual fund.

The SEC is concerned that the descriptions of risk in mutual fund

prospectuses are not as helpful or as clear as they could be. The SEC

is seeking ideas and suggestions on how these descriptions of risk may

be improved. Your ideas and suggestions may shape how risks are

explained in the future and help investors make better investment

choices.

Here are a series of questions and examples on how the descriptions

of risk may be improved. We urge you to respond, whether you answer one

question or all, or just have general comments. Feel free to use this

form or write a separate letter marked ``File No. S7-10-95.''

Please mail your comments to the SEC no later than July 7, 1995.

Directions for sending your comments to the SEC are provided at the end

of this document. The SEC will make your comments and other comments

received by the SEC available to the public.

How do you learn about mutual fund risks? The SEC would like to

know how you learn about the risks of a mutual fund before you invest

in the fund.

Do you learn about mutual fund risks from the fund

prospectus, a broker or bank representative, an investment adviser, a

family member or friend, magazines, newspapers, or other publications?

If you use more than one of these sources, please list all of the

sources that you use.

What information do you find most useful in evaluating

mutual fund risks? What can the SEC do to provide information about the

risks of investing in mutual funds that other sources of information do

not do?

How well do mutual fund prospectuses describe the risks of

investing? The SEC would like to know if you find the way mutual fund

prospectuses describe the risks of investing to be helpful.

Do mutual fund prospectuses give you a good idea of the

risks of investing? What do you like about the way mutual funds

describe risk in their prospectuses and what would you like funds to do

differently?

Would you like all mutual fund prospectuses to contain a

summary of the risks of investing in the fund? If so, what would you

like to see in the summary?

Provide copies of any mutual fund descriptions of risk

that you believe are very helpful or unhelpful. Tell the SEC what you

like or don't like about the descriptions.

What do you want to know about risk? Risk means different things to

different people. The SEC would like to know how you define risk.

Do you define risk as:

(1) the chance that you will lose part of your investment;

(2) the chance that your investment will earn less than a certain

amount, for example, a fixed percentage, such as 5% per year, or the

return on a no-risk investment, such as a bank CD or U.S. treasury

bill, or the return on a stock or bond index, such as the Standard &

Poor's 500 stock index; or

(3) the variability in your fund's return, that is, the month-to-

month or year-to-year ups and downs in your fund's share price or its

distributions?

Or do you define risk in some other way?

In choosing a mutual fund, are you most interested in

comparing the risks of investing in the fund to the risks of putting

your money in:

(1) investments that are not mutual funds, for example, bank CDs or

individual stocks and bonds;

(2) other mutual funds of all types;

(3) mutual funds of the same broad type, for example, stock funds

or bond funds; or

(4) mutual funds with the same investment objective, for example,

short-term bond funds?

Is your need for information about the risks of investing

in mutual funds greater for stock funds or bond funds, or is your need

for information about risk the same in both cases? Explain.

Would you like risk to be described with numbers, graphs, or

tables? The SEC is looking at a variety of ways that mutual funds could

tell investors about risk in addition to, or instead of, descriptions

in words. The SEC would like your ideas and suggestions about which of

those ways would be most helpful to you.

Do you find information most helpful when it is in the

form of written descriptions, numbers, graphs, tables, charts,

pictures, or some other form?

Mutual funds today are required to provide investors with their

annual returns for each of the past 10 years. By looking at these

returns, investors can get an idea of how variable a fund's returns

have been. This variability could be illustrated with a bar graph like

the following.

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Would you find a bar graph like the above helpful in

understanding the ups and downs in a mutual fund's annual returns?

Would it increase your understanding of a fund's risk if the fund also

provided you a bar graph of the returns of a market index, such as the

Standard & Poor's 500 stock index?

The SEC is looking at the possibility of requiring mutual funds to

use numbers to tell investors about the risks of investing. Examples of

the numbers that the SEC is considering as required risk measures are:

Standard Deviation of Total Return. This number measures

how variable a fund's total returns have been, that is, how much they

have gone up and down. The larger the standard deviation, the more

variable a fund's total returns have been.

Duration. This number measures how sensitive a bond fund's

value is to changes in interest rates.

If you have ideas about what risk measurement numbers the SEC

should ask mutual funds to give to investors, the SEC would like to

hear those ideas.

Should the SEC require funds to disclose standard

deviation or duration or any other specific risk measures? Why or why

not?

Should mutual funds rank their risk levels? The SEC is considering

whether it would be useful and practical for mutual funds to rank

various aspects of risk. For example, bond funds could be required to

tell investors whether their exposures to interest rate changes,

default risks, and currency fluctuations are low, medium, or high. This

could be done in the form of a chart like the following.

Risk Summary

------------------------------------------------------------------------

Interest Default

Portfolio rate risk risk Currency risk

------------------------------------------------------------------------

High-Yield Fund.................. Medium.... High...... Low.

Global Bond Fund................. Medium.... Medium.... High.

Mortgage-Backed Security Fund.... High...... Low....... Low.

------------------------------------------------------------------------

Would it be useful for funds to rank various aspects of

risk? Do you find the above chart helpful? Do you understand the types

of risk referred to in the chart and the significance of those risks?

How to mail your ideas and suggestions to the SEC:

This form can be mailed to the SEC by folding it in half,

with the return address showing. Please staple or tape this form

closed. No postage is necessary.

If you do not wish to use this form, you can write a

letter directly to the SEC. Mark your letter ``File No. S7-10-95,'' and

send it to Jonathan G. Katz, Secretary, Securities and Exchange

Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

Remember to send your ideas and suggestions by July 7,

1995.

Do you want further information about what the SEC is considering?

If you would like a copy of the complete SEC release that

describes what the SEC is considering, write to Office of Consumer

Affairs, Securities and Exchange Commission, Attn: Michael Strupp, Mail

Stop 2-6, 450 Fifth Street, N.W., Washington, D.C. 20549.

Thank you for responding.

Your Name--------------------------------------------------------------

Street Address---------------------------------------------------------

City-------------------------------------------------------------------

State------------------------------------------------------------------

Zip--------------------------------------------------------------------

[FR Doc. 95-8143 Filed 4-3-95; 8:45 am]

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