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Originally published Saturday, December 7, 2013 at 8:02 PM

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Fair disclosure rules should be applied to funds | Chuck Jaffe

The compromise and the obvious solution goes back to what we learned in grade school: If funds exercise the option to disclose their holdings more often than required, they should be required to give that extra-information candy to everyone, or to no one at all.


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Your Funds

As schoolchildren, we learned that if we wanted to give our special friends a cookie or a piece of candy, we needed to have something for the whole class. That was considered fair.

The mutual-fund business, however, is not fair.

That’s especially true when it comes to how funds disseminate their trade secrets, the portfolio-holdings records that, truthfully, are the intellectual property of shareholders but which are treated as if they are the inside information of the fund’s manager.

The entire fund community is facing a Big Data problem, where massive amounts of information about what funds do is being collected, then evaluated by industry sharpies in ways that were not possible a decade ago, in the hope that sophisticated analysis will lead to indicators of managerial activity that can create a brief trading edge.

In short, it looks like there are an increasing number of traders, hedge-fund managers and others trying to use portfolio data against the funds that create it.

A key issue underlying the problem is how portfolios are released.

While funds are required to release their holdings every quarter, many give out that information monthly, but limit the extra distribution to research firms, institutional investors like pension funds, and third parties that have what is routinely called “legitimate business interests.”

Funds are given a choice in how to release the data; some make everything available on their websites except for any active trading activity that might be disrupted by disclosure; others make the extra information available only to those special friends.

While those parties agree not to disclose material information, there’s little doubt that the details are being used against funds, typically by other money managers looking to see where fund managers are moving, creating opportunities.

It’s not necessarily as simple as Fund X releases information, and then sees bad guys “front-running” key positions in the portfolio.

That’s the fear everyone has over disclosure, but this situation is much more about how a shrewd trader can use, say, all of the activity from all funds in a big complex to fine-tune forecasts of what the firm’s analytical team is thinking.

Because you can’t quantify the cost of losses suffered at the hands of Big Data pirates, fund firms and regulators are not addressing the problem.

Most don’t want to acknowledge its existence, except for passages buried deep in the legalese of fund documents.

The SEC has long tried to make sure that disclosures were made fairly. Regulation FD (for Fair Disclosure) dates to 2000 and it provides that public companies must not make selective disclosure of private information to analysts without making the same information available to the general public.

It exempts mutual funds (except for closed-end instruments), and also allows for giving information to those special friends.

Thus, fund firms don’t believe they have any responsibility to provide fair disclosure.

Further, fund companies don’t believe shareholders would even truly understand the portfolio disclosures without some analytical tools to decipher it.

That does not change the fact that the additional disclosures of information may be used against the funds; moreover, whether the consumer/shareholder fully understands what is being released is not the issue here, being fair is.

That’s why disclosure rules need to be changed.

Allowing funds to only release data quarterly — stopping the flow of any extra disclosures — is not a great solution, especially at a time when transparency is the watch word of the business. More disclosure generally is seen as better by funds and industry watchers; the issue is fairness.

Requiring more regular disclosure by forcing everyone to make monthly updates isn’t a good answer either; it adds a burden on those fund firms that prefer quarterly disclosure and that keep data to themselves — sans special friends — the rest of the time. That’s anywhere from 30 to 50 percent of all funds, depending on whose estimate of the industry you trust.

The compromise and the obvious solution goes back to what we learned in grade school: If funds exercise the option to disclose their holdings more often than required, they should be required to give that extra-information candy to everyone, or to no one at all.

Forget special friends, because fund boards really have no clue how this information is used or how well confidentiality agreements work (hint: not very well); if you can’t give the intellectual property to the people who own it, it should not go out to anyone.

If directors don’t believe more regular disclosures are prudent, the fund doesn’t have to make them, but the flow of extra information stops, completely.

And if a fund firm is willing to give additional disclosures, it makes the data available to all.

This situation will get worse the longer it goes unchecked; analysts are just scratching the surface on uses for Big Data, and they get more ammunition for their efforts every day. Ignoring the problem won’t make it go away.

Regulators need to fix fund-disclosure rules now, or they’re sending the wrong message, as surely as those teachers feel that kids send the wrong message by selectively excluding classmates from their treats.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.

Copyright 2013, MarketWatch



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