Resolution of bond fund ratings expected

Mutual funds

December 28, 1997|By Jerry Morgan | Jerry Morgan,NEWSDAY

The battle over bond fund risk -- excuse us -- ratings is about to be resolved.

These are ratings that mutual-fund companies can buy from bond-rating agencies such as Standard & Poor's, which upsets the fund industry.

The board of directors of the National Association of Securities Dealers earlier this month approved an 18-month trial period for bond fund volatility ratings, with conditions. But the ratings won't be used until after the Securities and Exchange Commission approves the NASD action, which could take six months.

The Investment Company Institute, the trade group of the mutual-fund industry, was battling Standard & Poor's to prevent it from producing a risk rating for bond mutual funds, claiming that the rating is subjective and predictive of fund risk, which regulators do not allow.

Opponents say it is hard to define risk, so the ratings should measure sensitivity to interest rate fluctuations, which is called volatility; hence the cosmetic name change. The regulatory division of the NASD also had opposed the S&P proposal, which was to allow fund companies to use the risk ratings in supplemental sales literature, but not in advertising.

But, since SEC Chairman Arthur Levitt favors more disclosure, the NASD's regulatory division reconsidered. It also modified what S&P and a fund company can say about a product. About 80 funds in the institutional market now have the ratings, said aide Sandy Bragg, S&P's managing director for mutual funds, because the rules for institutional fund investors are different from those for individual buyers, who regulators think need greater protections.

Under the NASD rules, for example, S&P has to provide a narrative description of risk, not just a single symbol, like the AAA ratings it uses for bonds. And it has to use objective data, not just subjective interviews with fund managers, to reach the rating.

Further, NASD said the mutual-fund company must disclose the fact that the ratings were paid for as well as any other ratings the fund received, so investors can be sure the company is not just buying the best rating it can. There must also be a disclaimer that the rating is not a recommendation to buy the fund.

The Investment Company Institute's objection to the ratings' predictive aspect -- how the fund will fare in the future -- worried industry officials, who said they feared that people would use the ratings to decide which funds to buy. They pointed to the star rating system used by Chicago's Morningstar Inc., which is based on historical data that can be replicated and is provided free.

But there is disingenuousness on the part of those who point to the Morningstar ratings as somehow more pristine. Fund companies advertise those ratings all the time and brag about how many of their funds have the coveted four- and five-star designations. Studies have shown that funds receiving high ratings sell better than other funds. Even Morningstar President Don Phillips acknowledged that he is uncomfortable about the way his ratings are used.

But Craig Tyle, general counsel for the Investment Company Institute, said the industry believes that the S&P rating system is flawed and worries that "we will have a new kind of Gresham's law where bad disclosure will drive out good disclosure."

There is another industry fear: that funds will feel forced to buy the ratings (which start at $25,000 for the first fund,) just to stay competitive. Not all the ratings are favorable. Some companies' funds are rated B, which means "extremely high risk, extremely sensitive and may possess speculative characteristics."

Here's another example of the truism that the mills of the regulators grind exceedingly slow.

We've been telling you for the past two years that the SEC's new profile prospectus will be heading your way soon.

Well, the new short-form, 11-answer prospectus will be heading your way soon, perhaps early next year, say SEC officials.

The profile prospectus, for those who haven't been following this soap opera, is an attempt to create a document fund buyers will actually read before they make a purchase. Studies have shown that investors don't read the regular prospectus because they are unreadable, unintelligible, turgid, cover-your-butt documents written by and for lawyers.

The new form, which has been test-marketed by eight fund companies for two years, requires funds to spell out in plain English the answers to 11 questions, including the risks of the fund, what it invests in, the costs, the manager, etc.

The form is supported by the fund industry and SEC Chairman Levitt, so one would think it would have been pushed through quickly. But the short form has to get past the lawyers to state in plain English what the customer is buying. And deciding what to leave out requires lawyers to work out liability problems.

"The devil is in the details," said Tyle of the Investment Company Institute. "There are a lot of details that need clarification, and it can be frustrating to try to boil it down."

Barry Barbash, who heads the SEC's Division of Investment Management, which oversees mutual funds, has to wade through the industry comments on the short-form prospectus as well as changes in the regular prospectus. He said there were many liability issues that had to be dealt with. As for the delay, he said, "Don't read too much into it. It is just the rule-making process."

Add two new SEC commissioners who have to be brought up to speed, and the loss of some staff members to the booming fund industry, and you have delays. "We had been targeting early fall of this year, not 1998," said Barbash.

Pub Date: 12/28/97

Baltimore Sun Articles
|
|
|
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.