Comment Letter

February 14, 2003

Mr. Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549

Re: Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management Investment Companies (File No. S7-51-02)

Dear Mr. Katz:

The Investment Company Institute¹ appreciates the opportunity to comment on the Commission's proposals to improve the disclosure provided in registered management investment company reports to shareholders and to require such companies to disclose their complete portfolio holdings on a quarterly basis.²

The Institute strongly supports the Commission's proposals that address the information contained in fund shareholder reports. We commend the Commission for continuing its efforts to improve disclosures provided to fund investors by making shareholder reports more comprehensible, informative and useful to the average investor. This initiative is an appropriate "next step" that builds on the Commission's 1998 overhaul of mutual fund prospectuses, authorization of fund profiles, and adoption of "plain English" requirements, all of which the Institute supported.³ We are pleased that many of the Commission's proposed changes to improve shareholder report disclosure are consistent with recommendations the Institute previously has submitted to the Commission.⁴ We also support the Commission's efforts to enhance investor understanding of fund fees and expenses.

The Institute questions the benefits, however, of requiring all funds to disclose their portfolio holdings more frequently than semi-annually, and we remain concerned that this would facilitate abusive trading practices that will harm fund shareholders. Nevertheless, we would not oppose the Commission's proposal to require quarterly portfolio holdings disclosure with a 60-day lag, provided that it were revised as discussed below to address these concerns.

In summary, our comments are as follows:

Each of these comments is discussed in greater detail below.

A. Summary Portfolio Schedule
B. Exemption for Money Market Funds
C. Tabular or Graphic Presentation
D. Disclosure of Fund Expenses
E. Management's Discussion of Fund Performance

A. General Comments
B. Reports on Form 13F
C. Proposed Form N-Q

I. Proposals to Improve Disclosure in Shareholder Reports
A. Summary Portfolio Schedule
1. GENERAL COMMENTS
The Commission has proposed to permit funds to include a summary portfolio schedule in their reports to shareholders, while making the complete schedule available free of charge upon request to those investors who are interested in more detailed information. Under the proposal, funds would be required to disclose their 50 largest holdings and any holdings that account for at least one percent of net assets.

The Institute strongly supports this proposal. We agree that for funds with large numbers of portfolio holdings, a streamlined schedule of investments would provide more meaningful information to investors than numerous pages listing all fund investments. It would encourage investors to focus on a fund's most significant investments when evaluating its risk profile and investment strategy. In addition, as noted in the Proposing Release, the ability to provide a summary portfolio schedule should result in reduced printing and mailing costs for shareholder reports.

2. FORMAT OF SUMMARY PORTFOLIO SCHEDULE
Under the proposal, the summary portfolio schedule would be required to list securities in order of descending value. The Proposing Release requests comment, however, on whether the Commission should adopt a different approach, such as listing portfolio securities by identifiable category.⁵ The Institute recommends that the Commission not prescribe a specific format for the summary portfolio schedule. So long as the schedule contains at least the information the Commission has proposed to require,⁶ we do not believe that a standardized format is necessary.

Providing flexibility with respect to the format of the summary schedule is consistent with the Commission's proposal, discussed below, to require graphic presentations of portfolio holdings but allow funds to determine the format. Funds should have leeway to use creativity in designing summary portfolio schedules and graphic presentations that complement each other to provide shareholders with important, "user-friendly" information about the nature of the fund's investments.⁷ For example, an international fund could organize its portfolio schedule by country and provide a corresponding graphic presentation depicting the allocation of fund portfolio holdings among different countries.

3. TYPES OF INVESTMENTS INCLUDED IN SUMMARY PORTFOLIO SCHEDULE
As proposed, the portfolio holdings listed in the summary portfolio schedule would be limited to investments in securities of unaffiliated issuers; funds would still be required to disclose in full other types of investments.⁸ The Institute recommends that the Commission revise the proposal to extend it to any (1) investment other than securities or (2) investment in an affiliate⁹ that is one of the fund's 50 largest holdings or constitutes one percent or more of the fund's net assets. Our recommendation would be consistent with the theory behind the summary portfolio schedule, which is that investors are well-served by disclosure that focuses their attention on the fund's most significant investments.¹⁰ It also would make the Commission's proposal more consistent with GAAP for investment companies, which contemplate a summary schedule of investments that includes all types of investments.¹¹

We understand that Commission staff and independent accountants may currently require funds to include short-term investments made with cash collateral from securities lending in their schedule of investments. We recommend that the Commission clarify that such collateral should be excluded from the summary portfolio schedule. (It would continue to be reflected elsewhere in a fund's financial statements.) To the extent that the value of investments representing cash collateral from securities lending constituted a significant percentage of a fund's net asset value, it would not be appropriate to portray such collateral as representing part of the fund's primary investments by including it in the summary portfolio schedule because this could create a distorted view of how the fund's portfolio is invested. Moreover, including these short-term investments in the summary schedule may cause certain of the fund's primary investments to fall out of the top 50 holdings.¹²

4. CRITERIA FOR IDENTIFYING AND DISCLOSING HOLDINGS
As noted above, the Commission's proposal would require funds to include in the summary portfolio schedule the 50 largest issues held by the fund and any other securities the value of which exceeded one percent of the fund's net asset value as of the close of the reporting period. For purposes of determining whether the value of a security exceeds one percent of net asset value, funds would be required to aggregate and treat as a single issue all securities of any one issuer.¹³ For purposes of listing holdings in the summary schedule, however, each issue would be required to be listed separately, whether or not issued by a single issuer.¹⁴

The Institute is concerned that the proposed requirement to list each such holding separately would essentially nullify the benefits of the summary portfolio schedule in some cases. For example, it appears that under the proposal, a U.S. government securities fund would be required to list separately each issue that it owned (other than short-term debt or fully collateralized repurchase agreements). We believe this is an unintended and inappropriate result, and strongly encourage the Commission to revise its proposal to address this concern.

5. SHAREHOLDER REPORTS FOR MULTIPLE FUNDS
The Proposing Release seeks comment on whether a shareholder report covering more than one fund should be required to use the same type of portfolio schedule (summary or complete) for all funds included in the report.¹⁵ The Institute urges the Commission not to constrain the ability of multiple funds that are included in a single report to shareholders to choose to use different types of portfolio schedules. There likely will be circumstances in which the same type of portfolio schedule is not optimal for all funds included within one report, due to the distinct nature of the funds' portfolios. Funds that choose to use a combined shareholder report should not be either precluded from taking advantage of the summary portfolio schedule, or forced to use it, for the sake of uniformity.¹⁶ Shareholders in many cases will own shares of only one of several funds included in the same report; therefore, inclusion in the same report does not in and of itself provide a compelling basis for requiring use of one type of portfolio schedule.

6. "MISCELLANEOUS SECURITIES" PROVISION
Note 1 to Rule 12-12 of Regulation S-X (Investments in Securities of Unaffiliated Issuers) provides an exception from the requirement to list each issue separately in the fund's complete portfolio schedule. It states that "an amount not exceeding five percent of the total of Column C may be listed in one amount as `Miscellaneous securities,' provided the securities so listed are not restricted, have been held for not more than one year prior to the date of the related balance sheet, and have not previously been reported by name to the shareholders of the person for which the schedule is filed or to any exchange, or set forth in any registration statement, application, or annual report or otherwise made available to the public." The Commission's summary portfolio schedule proposal does not contain a parallel provision. Consequently, funds that wish to take advantage of this provision would not be able to do so with respect to securities that meet the "miscellaneous securities" criteria described above but that constitute one of the fund's fifty largest holdings or account for one percent or more of the fund's net assets. Funds that wish to use the summary portfolio schedule should not be forced to reveal prematurely certain positions in securities of unaffiliated issuers. We therefore recommend that the Commission revise its proposal to incorporate an exception similar to that in Rule 12-12.¹⁷

7. AVAILABILITY OF COMPLETE PORTFOLIO SCHEDULE
As noted above, the Commission's proposal would require a fund that uses a summary portfolio schedule to provide a complete schedule to investors upon request, free of charge.¹⁸ The Proposing Release requests comment on whether a fund that uses a summary portfolio schedule should be permitted to provide its complete portfolio schedule to investors exclusively through posting this information on its website.¹⁹ The Institute strongly supports giving funds this option, and further recommends that the Commission permit funds to satisfy the requirement by providing a hyperlink to the Commission's EDGAR website. We note that this approach would be consistent with other new Commission disclosure requirements,²⁰ and believe that it is appropriate to provide funds with similar flexibility in making their complete portfolio holdings schedules available.

B. Exemption for Money Market Funds
Under the Commission's proposal, money market funds would be exempt from the requirement to provide a schedule of investments in securities of unaffiliated issuers in their reports to shareholders.²¹ The Institute strongly supports this proposal, which appropriately recognizes the strict restrictions that Rule 2a-7 under the Investment Company Act of 1940 imposes on money market fund portfolios.²²

The Proposing Release requests comments on whether the exemption for money market funds from including a portfolio schedule in shareholder reports should apply to all of the required schedules, or only the schedule of investments in unaffiliated issuers.²³ We recommend that the proposal be expanded to apply to all of the required schedules.²⁴ It would seem odd and possibly confusing to list other investments, which often may represent only a small proportion of the fund's portfolio, while omitting the schedule of securities of unaffiliated issuers.²⁵

C. Tabular or Graphic Presentation
The Commission has proposed to require each fund to include a presentation in its reports to shareholders that uses tables, charts or graphs to depict the fund's portfolio by reasonably identifiable categories, such as industry sector, geographic region, credit quality or maturity. The Institute strongly supports this proposal. Many funds already provide this type of disclosure voluntarily to facilitate shareholders' understanding of fund portfolio composition. Requiring it for all funds will benefit investors by making it more broadly available.

Under the Commission's proposal, funds would have the discretion to determine the format and content of the presentation. The Institute supports this approach because it recognizes the diversity of investment strategies available and provides the necessary flexibility to funds to design an appropriate presentation that is informative and comprehensible to shareholders.

Notwithstanding our strong support for the Commission's proposal, we are concerned about some of the proposed rule language that would implement the graphical presentation requirement. Proposed Item 21(d)(2) of Form N-1A indicates that the "categories should be selected, and the format of the presentation designed, to provide the most useful information to investors about the types of investments made by the Fund, given its investment objectives." ²⁶ While providing "the most useful information" to investors should be the goal, articulating a regulatory standard in those terms is problematic. The usefulness of the information provided will be a subjective judgment, and to require that it be "the most useful" would be an open invitation to second-guessing. The Institute recommends that the wording of the proposed requirement be changed to specify that funds must provide useful information to investors.

The Commission's proposal would require the graphical presentation to indicate the percentage of the fund's net asset value attributable to each category depicted. The Institute recommends that funds be permitted, in the alternative, to provide a presentation that is based on the fund's total investments. We note that the AICPA Investment Company Audit Guide authorizes funds to categorize fund holdings in the schedule of investments based on either net assets or total investments.²⁷ Both our recommendation and the Investment Company Audit Guide reflect the fact that neither approach is inherently superior; either could be appropriate so long as the basis for the presentation is clearly identified.²⁸

In addition, consistent with our comment set forth above with respect to the summary portfolio schedule, we recommend that the Commission clarify in the adopting release that securities purchased with cash collateral from securities lending should be excluded for purposes of the graphic presentation. Otherwise, the presentation could create the impression that short-term debt securities are a major component of a fund's portfolio holdings in situations where it would be inappropriate to do so because they are not held as part of the fund's managed investments.      

D. Disclosure of Fund Expenses
The Commission's proposal would require new disclosure concerning ongoing expenses in fund shareholder reports. In particular, each fund would have to disclose in its reports to shareholders: (1) the cost in dollars of a $10,000 investment in the fund, based on the fund's actual expenses and return for the reporting period; and (2) the cost in dollars of a $10,000 investment in the fund, based on the fund's actual expenses and an assumed return of 5 percent per year. The dollar amount disclosures would be accompanied by a prescribed narrative explanation. According to the Proposing Release, the purpose of the proposed disclosure is "to increase investor understanding of the fees that they pay on an ongoing basis for investing in a fund."²⁹

1. GENERAL COMMENTS
The Institute agrees that it is important for mutual fund investors to understand how fees and expenses affect their investments and returns. We note that mutual funds already are required to provide detailed disclosure of their fees and expenses in a standardized table at the front of the fund prospectus, including a hypothetical example designed to illustrate the costs of a fund investment over specified periods (one, three, five and ten years). In addition, funds are required to present their performance net of fees. As a result, the transparency of mutual fund fees and expenses far exceeds that of any other financial product. Moreover, in recognition of the importance of investor understanding of mutual fund fees and expenses, the Commission and the fund industry alike have developed special tools and other materials designed to educate investors concerning fund fees and expenses.³⁰

The proposed shareholder report expense disclosure would provide shareholders with additional, useful information that should assist them both in understanding the impact of expenses on their investment return and in comparing expenses across different funds. Accordingly, we support the Commission's expense disclosure proposal, subject to the comments discussed below.³¹ Moreover, we agree that, because the proposed disclosure would provide historical cost information, it is appropriate to place it in the shareholder report along with other backward-looking information for the period covered.

The Institute also strongly commends the Commission for proposing an approach through which it expressly seeks to balance the benefits of additional disclosure requirements with the costs and burdens of such requirements.³² In this regard, the Proposing Release describes a report on mutual fund fees issued by the United States General Accounting Office (GAO) in 2000 in which the GAO concluded that additional disclosure could help increase investor awareness and understanding of mutual fund fees and promote competition among funds on the basis of fees. The GAO report recommended that the Commission require funds to provide each investor with an exact dollar figure for fees paid in each quarterly account statement, but also acknowledged the potential costs of such a requirement and encouraged the Commission to consider less costly alternatives.³³ The Proposing Release indicates that the Commission considered the GAO's recommendation for individualized expense disclosure in each quarterly account statement but determined that it would be more appropriate to propose including additional expense disclosure in shareholder reports, because the costs of the GAO's proposed approach may outweigh the benefits.³⁴

The Institute agrees with the Commission's conclusion. Implementation of the GAO's recommendation would involve significant costs and logistical challenges because it would require not only funds and their servicing agents, but also the multitude of financial intermediaries through which fund shares are distributed, to develop and maintain coordinated systems capable of producing account statements containing the required disclosure. Over 80 percent of fund transactions involve the assistance of a financial intermediary, such as a broker-dealer, financial planner, bank, trust company, registered investment adviser, employee retirement plan, or financial "supermarket."³⁵ Current systems of and linkages among funds, their service providers and financial intermediaries simply do not accommodate the calculation of individualized shareholder expenses, nor do they support the communication and presentation of such information.

To better understand the extent and nature of the costs to comply with the GAO's individualized expense disclosure recommendation, the Institute conducted a survey of various industry participants in late 2000.³⁶ The survey found that the aggregate costs to survey respondents associated with calculating and disclosing the actual dollar amount of fund operating expenses attributable to each investor on quarterly account statements would be $200.4 million in initial implementation costs and $65 million in annual, ongoing costs.³⁷ It is important to note that the aggregate costs of the survey participants necessarily understate, most likely by a significant amount, the total costs that would be incurred by mutual funds, service providers, financial intermediaries and ultimately fund investors if the GAO recommendation were adopted, because the survey participants represented only a sample of affected organizations.³⁸

Consistent with the findings of the Institute survey, the cost/benefit analysis in the Proposing Release predicts that the cost of providing fund shareholders with individualized information about the fees and expenses that they paid in quarterly account statements "would greatly exceed the cost of [the Commission's] proposal" and estimates that industry-wide costs "could easily exceed $100 million annually."³⁹ In contrast, the Commission's proposal would provide valuable information to investors while avoiding the very substantial costs and burdens that would result if individualized expense disclosure were required.

Moreover, while it is clear that the costs of individualized expense disclosure on account statements would be high, we believe that any benefits of such disclosure would be limited. Indeed, in our view, account statement expense disclosure would have several disadvantages. First, it would not provide any context for an investor to assess the expenses paid in a meaningful way or to make comparisons with different funds. For example, the account statement might reflect investments in several funds but, because the amount invested in each fund likely would be different, it would be hard to make a fair comparison of the expenses paid for each. By contrast, the Commission's proposed approach, which uses a standardized investment amount, is specifically designed to facilitate comparisons among funds. As such, we believe it would promote the goals articulated in the GAO report-increasing investor awareness and understanding of mutual fund fees and promoting competition among funds on the basis of fees. Second, it could be misleading for account statements to disclose fund expenses, because there could be other investments reflected on the same statement that would not include similar disclosure. This would imply, incorrectly, that mutual funds are the only type of investment that involves costs. Placing expense disclosure in fund shareholder reports, as proposed by the Commission, would avoid this problem. Finally, respondents to the Institute's cost survey identified certain concerns that the GAO recommendation for individualized expense disclosure on account statements would raise, including the likelihood of longer processing time frames, which would result in delays in delivering account statements. The Commission's proposal would not raise this concern.⁴⁰

Based on the foregoing, we support the Commission's proposal to require additional expense information in shareholder reports, and not in quarterly account statements.

2. REQUIREMENT TO DISCLOSE TWO DIFFERENT EXPENSE NUMBERS     
Under the Commission's proposal, funds would be required to present two different expense numbers-one based on the fund's actual return over the period and the other based on a hypothetical 5 percent annual return. We believe the expense information would be more understandable to investors if the Commission simplified the disclosure and required only the first dollar amount figure, for the reasons set forth below.

First, we are concerned that presenting two numbers introduces an unnecessary level of complexity by requiring explanation of the purposes of each and the differences between the two. In addition to being complex, the required disclosure could become quite voluminous, especially in the case of funds with multiple classes that would have to disclose two sets of numbers.

Second, two numbers are not necessary to accomplish the Commission's objectives. The first number would provide information to shareholders about actual expenses paid during the reporting period and allow investors to estimate the actual costs that they bore. In addition, because it is based on a standardized, $10,000 investment, it would provide a basis for comparison of the expenses of different funds. Thus, the second proposed number-the cost in dollars of a $10,000 investment, based on the fund's actual expenses and an assumed return of 5 percent per year-would be largely superfluous.

Moreover, this latter proposed number has certain specific drawbacks. For example, by using a hypothetical rate of return, it would diverge from the goal of providing investors with information about actual expenses paid.⁴¹ In addition, it would be similar, but not identical, to the hypothetical dollar amount expense information that is required to be set forth in an example accompanying the fee table in fund prospectuses.⁴² (One difference between the two is that the dollar figures in the fee table example reflect sales charges, whereas the proposed shareholder report dollar figure would not.) The similarities and differences between the two illustrations could be confusing to investors. While it might be possible to clarify these issues through narrative explanations, this would only lead to more lengthy and complicated disclosure, contrary to the overall intent of the Commission's shareholder report initiative. And, given that the first expense number the Commission proposes to require in fund shareholder reports would satisfy the goals the Commission seeks to achieve, we believe that a better course of action would be to eliminate the second proposed number.

E. Management's Discussion of Fund Performance
A mutual fund, other than a money market fund, currently is required to include in its prospectus a discussion of the factors that materially affected the fund's performance during the past fiscal year ("MDFP"), unless the information is included in the fund's latest annual report to shareholders. Most funds currently include the MDFP in their annual reports, and the Commission has proposed to require funds to do so.

The Institute in the past has supported requiring the MDFP to be placed in funds' annual reports.⁴³ We note, however, that the Commission recently adopted new Form N-CSR, which will require the principal executive and principal financial officers of registered management investment companies to certify the entire contents of shareholder reports.⁴⁴ The Institute remains concerned that applying the certification requirement to the MDFP will have a negative impact on the quality of the MDFP. In particular, funds may be reluctant to include subjective, albeit useful, information (such as the portfolio manager's opinion about why the fund performed as it did during the period covered), because it does not readily lend itself to meaningful certification.⁴⁵ In light of these concerns, we believe that funds should continue to have the option of including the MDFP either in the prospectus or in the annual report.

The Commission requested comments on whether it should make any changes to the content of the MDFP.⁴⁶ The Institute does not believe any changes to the current requirements are needed. As mentioned in the Proposing Release, the staff has been asked to focus on MDFP disclosure in its review of fund disclosure documents. We support these efforts to check compliance with the existing requirements.

II. Proposal to Require Quarterly Filing of Portfolio Holdings
A. General Comments
In addition to proposing the changes to the contents of shareholder reports discussed above, the Commission has proposed to require funds to file their complete portfolio holdings schedules with the Commission on a quarterly basis, rather than semi-annually. As discussed below, although we question the benefits of this requirement, and remain concerned about the risks involved, the Institute would not oppose the Commission's proposal if it were revised to provide additional protection against these risks. 

The Proposing Release suggests that requiring more frequent portfolio holdings disclosure could have several benefits. We are skeptical about the magnitude of any such benefits. For example, the Release mentions that investors may be interested in using quarterly portfolio holdings information for various purposes, such as to monitor a fund's compliance with its stated investment objective.⁴⁷ In a 2001 submission to the Division of Investment Management expressing our views on proposals to require funds to disclose their portfolio holdings more frequently than semi-annually, we noted, among other things, that our members had experienced virtually no demand for such disclosure from their shareholders.⁴⁸ In fact, members that had reported their holdings quarterly and subsequently discontinued the practice received no complaints from their shareholders.⁴⁹ After we made the submission, we conducted an investor survey designed to assess shareholders' use of portfolio disclosure provided in fund shareholder reports and to gauge shareholders' interest in receiving this information more often than semi-annually.⁵⁰ The survey results confirmed a lack of fund shareholder interest.⁵¹

The Proposing Release asserts that another possible benefit of more frequent disclosure of portfolio holdings could be to discourage abusive practices known as "window dressing" and "portfolio pumping."⁵² We note, however, that the Commission has provided no evidence of funds engaging in these practices. And we continue to believe, as we stated in our 2001 submission, that, to the extent such practices may occur, the Commission has ample authority to address them through its inspections and enforcement programs.⁵³

In addition to questioning the benefits, our 2001 submission expressed concerns about the potential for harm to shareholders of some funds from requiring more frequent portfolio holdings disclosure. In particular, we noted that requiring such disclosure more frequently than semi-annually would expand opportunities for speculators and other professional traders to exploit the information in ways that are detrimental to fund shareholders. This could include, for example, "front running" fund trades in cases where an extended period of time is needed to build or reduce a position⁵⁴ and "free riding" on fund research and investment strategies.⁵⁵ According to the study commissioned by the Institute that accompanied our submission, if the required frequency of mutual fund portfolio holdings disclosure were increased, "the total return that shareholders receive from their mutual fund investments would likely be lower than under the current disclosure standard."⁵⁶

The absence of clear benefits and the risk of harm discussed in our 2001 submission and summarized above call into question the wisdom of requiring funds to disclose their portfolio holdings more frequently. At the very least, they strongly indicate that the Commission should proceed cautiously in this area.

The Commission's proposal does attempt to minimize potential harms to fund shareholders by requiring disclosure on a quarterly basis with a 60-day lag. As the Wermers Study makes clear, the frequency and timing of portfolio holdings disclosure are important factors influencing the degree of risk of harm to funds; generally speaking, the more frequent and current the disclosure, the greater the opportunities for abuse will be. Thus, we agree that the standard proposed by the Commission should present significantly less risk than one that involves more frequent disclosure (e.g., monthly) or a shorter lag period (e.g., 30 or 45 days).

Still, we remain concerned that even under the Commission's proposal, shareholders of some funds would suffer as a result of the actions of speculators and other outside investors. We believe that the Commission could minimize these risks if it revised the proposal to give funds additional flexibility to keep certain holdings confidential. We recommend, therefore, that the Commission allow funds, in their shareholder reports and reports on Forms N-CSR and N-Q, to keep confidential holdings that meet the standards for confidential treatment applicable to Form 13F under the Exchange Act.⁵⁷ This should be in addition to the five percent basket of "miscellaneous securities" currently permitted under Regulation S-X.⁵⁸ We believe that this additional flexibility would provide funds with a targeted mechanism, in appropriately limited circumstances, to help protect their shareholders from the losses that could result from revealing a program of acquisition or disposition of a security.

B. Reports on Form 13F
In addition to recommending that the Commission revise its proposal to require quarterly filing of portfolio holdings information in the manner discussed above, the Institute urges the Commission to take steps to curtail opportunities for speculators and other outside investors to take undue advantage of information about fund portfolio holdings by revising the requirements for reporting by institutional investment managers on Form 13F. We are pleased that the Commission, through its requests for comment, has expressed a willingness to reexamine the current requirements.

As we have indicated before,⁵⁹ there is evidence that the information contained in Form 13F reports is being used for purposes that were not contemplated by Congress when it enacted Section 13(f) of the Exchange Act⁶⁰ and that are harmful to mutual fund shareholders. Technological advances since the enactment of Section 13(f) have greatly increased the speed and ease with which the information in 13F reports may be accessed and disseminated, thereby making it possible to package the information in ways that facilitate predatory trading practices. Indeed, commercial services (such as those referred to above) that offer the ability to trade securities on the basis of information regarding the holdings of mutual funds appear to rely in significant part on information from 13F reports.

As the Institute has previously acknowledged, certain differences between the information in 13F reports and the schedule of investments in fund shareholder reports suggest that the disclosures included in 13F reports may not facilitate the same degree of harmful trading practices as disclosure of individual fund portfolio holdings.⁶¹ Nevertheless, like fund portfolio holdings disclosure, and especially when combined with such disclosure, 13F reports likely facilitate front running and free riding practices that hurt fund shareholders.⁶² An increase in the required frequency of fund portfolio holdings disclosure, as proposed by the Commission, could only be expected to exacerbate this situation, particularly for funds whose fiscal quarters do not correspond with calendar quarters. We note that for those funds, some form of portfolio holdings disclosure would be required eight times per year (by the individual fund within 60 days after the end of each fiscal quarter and as part of the investment manager's aggregated holdings disclosure in 13F reports within 45 days after the end of each calendar quarter.)

To minimize the abuses that may result from the availability of information contained in quarterly 13F reports, such as front running and free riding, we reiterate our recommendations that the Commission: (1) require semi-annual, rather than quarterly, reporting of this information; and (2) require the filing of such reports within 60 days after the end of the relevant period, instead of 45 days.⁶³

C. Proposed Form N-Q
Under the Commission's proposal, funds would be required to file complete portfolio schedules for their first and third fiscal quarters on proposed new Form N-Q. The Institute has the following comments on proposed Form N-Q.

First, as proposed, Form N-Q would have to be signed on behalf of the fund by the fund's principal financial officer or officer(s). The Proposing Release requests comment on whether the Commission should designate Form N-Q as a reporting form under Sections 13(a) and 15(d) of the Exchange Act, which would subject the form to certification requirements under Section 302 of the Sarbanes-Oxley Act of 2002.⁶⁴ The Institute supports the approach proposed by the Commission and would oppose designating Form N-Q as an Exchange Act reporting form. There is no indication whatsoever that Congress, in enacting the Sarbanes-Oxley Act, intended to expand the reporting requirements for investment companies under the Exchange Act and thereby to increase the scope of certification requirements applicable to them. The Commission should not use this rule proposal as a way to do so. The resulting burdens would outweigh any conceivable benefits.

Second, as discussed earlier in this letter, the Commission has proposed to exempt money market funds from including portfolio schedules in their shareholder reports, which the Institute supports. In explaining the basis for this proposal, the Proposing Release notes that money market funds' portfolio investments are highly circumscribed by Rule 2a-7, that a list of a money market fund's portfolio securities may not assist the average investor in evaluating the fund or distinguishing one money market fund from another, and that investors generally are less interested in the composition of money market fund portfolios than other types of funds.⁶⁵ The Institute agrees and believes that for the same reasons, money market funds should be exempted from the Form N-Q filing requirement and should continue to file their full portfolio schedules with the Commission semi-annually. We recommend that the Commission revise its proposal accordingly.

III. Effective Date
The Proposing Release states that if the proposed amendments are adopted, the Commission would expect to require all fund reports to shareholders filed for periods ending on or after the effective date of the amendments to comply with the proposed amendments, and to require funds to file quarterly reports on Form N-Q with respect to any fiscal quarter ending on or after the effective date.⁶⁶ The Institute supports this approach and recommends that the Commission provide an appropriate transition period by designating an effective date that is 120 days after the adoption of the amendments.

The Institute appreciates the opportunity to comment on the Commission's proposals. If you have any questions concerning our comments, or need additional information, please contact me at (202) 326-5815, Amy Lancellotta at (202) 326-5824 or Frances Stadler at (202) 326-5822.

Sincerely,

Craig S. Tyle
General Counsel

Attachments

cc: The Honorable Harvey L. Pitt
The Honorable Paul S. Atkins
The Honorable Roel C. Campos
The Honorable Cynthia A. Glassman
The Honorable Harvey J. Goldschmid

Paul F. Roye
Director, Division of Investment Management

Susan Nash
Associate Director, Division of Investment Management

Brian D. Bullard
Chief Accountant, Division of Investment Management

¹ The Investment Company Institute is the national association of the American investment company industry. Its membership includes 8,935 open-end investment companies ("mutual funds"), 559 closed-end investment companies, and six sponsors of unit investment trusts. Its mutual fund members have assets of about $6.382 trillion, accounting for approximately 95 percent of total industry assets, and 90.2 million individual shareholders.

² SEC Release Nos. 33-8164; 34-47023; IC-25870 (December 18, 2002); 68 Fed. Reg. 160 (January 2, 2003) ("Proposing Release").

³ See Letters from Paul Schott Stevens, Senior Vice President, General Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, Securities and Exchange Commission, dated June 9, 1997 (Form N-1A Amendments and Fund Profiles) and Letter from Paul Schott Stevens, Senior Vice President, General Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, Securities and Exchange Commission, dated March 24, 1997 (Plain English Disclosure).

⁴ See Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, Securities and Exchange Commission, dated August 11, 1998; see also Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Paul F. Roye, Director, Division of Investment Management, Securities and Exchange Commission, dated July 17, 2001, at 9 and Investment Company Institute, Proposals to Improve Investment Company Regulation (May 1, 2002) at 7-8.

⁵ 68 Fed. Reg. at 165.

⁶ This information would include name of issuer and title of issue, amount held, value, and percent of net assets.

⁷ It is our understanding that listing securities in the summary portfolio schedule in order of descending value may not comply with current generally accepted accounting principles ("GAAP") for investment companies, which require the summary schedule to be broken down by security type and industry. See AICPA Investment Company Audit Guide, ¶7.10. If this is the case, auditors may not be able to certify that the financial statements are prepared in conformity with GAAP. The Institute is hopeful that this potential conflict can be resolved, and urges the Commission to coordinate with the AICPA toward this end. In the mean time, however, this is another important reason to provide flexibility to funds regarding the format of the summary schedule.

⁸ In addition to Schedule I - Investments in securities of unaffiliated issuers, Regulation S-X requires management investment companies to provide the following four other schedules: Schedule II - Investments - other than securities; Schedule III - Investments in and advances to affiliates; Schedule IV - Investments - securities sold short; and Schedule V - Open option contracts written.

⁹ The Commission could require funds to identify investments in affiliated issuers by an appropriate symbol or footnote. Other information currently required by Schedule III (Investments in and advances to affiliates) could be provided in a footnote to the summary schedule or in a footnote to the financial statements. We recommend, however, that identification and the related information not be required with respect to investments that are deemed to be issued by an affiliate solely because the fund owns 5 percent or more of the issuer's outstanding voting securities. We believe that it is not necessary to highlight these investments as investments in affiliates and that doing so may confuse investors and/or cause them to draw inaccurate conclusions about the fund's relationship with the issuer.

¹⁰ Under our proposal, funds would continue to provide separate schedules reflecting any securities sold short and any open option contracts written. Intermingling short positions and options written with long positions in the summary schedule might be confusing in that the former two items represent liabilities rather than assets.

¹¹ See AICPA Investment Company Audit Guide ¶7.10.

¹² We note that our recommendation to exclude investments made with cash collateral from securities lending from the summary portfolio schedule could not be implemented without a corresponding change to GAAP requirements, and suggest that the Commission work with the AICPA to achieve consistency in this regard.

¹³ It is not clear whether a holding that is one of the fund's 50 largest issues would be aggregated with other issues of the same issuer for this purpose.

¹⁴ Under an exception to this general rule, the Commission's proposal would require funds, for purposes of the list, to aggregate and treat as a single issue, respectively, (1) short-term debt instruments of the same issuer, and (2) fully collateralized repurchase agreements. The Institute supports this approach.

¹⁵ 68 Fed. Reg. at 165.

¹⁶ Funds that do not have large numbers of holdings, for example, may have no reason to use a summary schedule.

¹⁷ As indicated infra at nn. 57-58 and accompanying text, funds also should be permitted to treat certain holdings as confidential, consistent with the standards for confidential treatment in Form 13F under the Exchange Act. We note that GAAP for investment companies do not currently provide for a "miscellaneous securities" category in the summary schedule or for confidential treatment of holdings that meet the Form 13F standards for confidential treatment. We encourage the SEC to work with the AICPA to address these potential conflicts.

¹⁸ Funds also would be required to provide disclosure in their annual and semi-annual reports to shareholders concerning the availability of the complete schedule.

¹⁹ 68 Fed. Reg. at 165.

²⁰ See SEC Release Nos. 33-8188, 34-47304, IC-25922 (January 31, 2003), 68 Fed. Reg. 6564 (February 7, 2002) at n. 49 (disclosure of investment company proxy voting records).

²¹ The Proposing Release requests comments on whether index funds should be exempted from the requirement to include their portfolio holdings in their reports to shareholders, as long as the holdings are filed with the Commission and made available to shareholders upon request. 68 Fed. Reg. at 165. The Institute would oppose such an exemption. We believe that index funds should be required to provide their shareholders with the same level and type of portfolio holdings information that shareholders of other non-money market funds will be required to provide (i.e., either summary or full portfolio schedules and tabular or graphic presentations of the portfolio). While such funds seek to track a designated index and thus generally have no discretion with respect to their portfolio holdings, not all index fund shareholders are intimately familiar with the composition of the particular index their fund seeks to track.

²² As noted in our 1998 letter to the Commission, in which we recommended exempting money market funds from the requirement to list portfolio holdings in shareholder reports, the AICPA's Investment Company Audit Guide makes no special provision for money market funds. Accordingly, they are required to disclose, at a minimum, their top 50 holdings. Thus, in order for the Commission's proposal to be realized, the Investment Company Audit Guide would need to be changed. As we suggested above with respect to (1) the format of the summary portfolio schedule, (2) the exclusion of investments made with cash collateral from securities lending from the summary schedule, and (3) the ability to designate a basket of "miscellaneous securities," the Commission should coordinate with the AICPA and encourage prompt resolution of this discrepancy.

²³ 68 Fed. Reg. at 165.

²⁴ See supra n. 8.

²⁵ We note that the practical impact of our recommendation appears to be limited to any investments in affiliates that a money market fund might have. The other schedules relate to investments that would not be listed in a money market fund shareholder report because they are not permitted under Rule 2a-7 (i.e., investments other than securities, short sales, and options). 

²⁶ 68 Fed. Reg. at 183 (emphasis added).

²⁷ See AICPA Investment Company Audit Guide, ¶7.78.

²⁸ In many cases, total investments and net assets would be similar; however, there are some circumstances in which total investments would exceed net assets, such as where a fund borrows money for investment purposes and invests those borrowings in securities, and others where total investments would be less than net assets, such as when fund assets that are not included in total investments (e.g., receivables, cash, unrealized gain on foreign currency contracts) exceed fund liabilities.

²⁹ 68 Fed. Reg. at 168.

³⁰ See 68 Fed. Reg. at nn. 14-15 and accompanying text.

³¹ Other important participants in the ongoing dialogue on disclosure of mutual fund fees also have expressed support for the Commission's proposal. See Letter from Michael G. Oxley, Chairman, U.S. House of Representatives, Committee on Financial Services and Richard H. Baker, Chairman, U.S. House of Representatives, Committee on Financial Services, Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, to The Honorable Harvey L. Pitt, Chairman, Securities and Exchange Commission, dated December 18, 2002 (commending the Commission for its expense disclosure proposal and stating that the proposal to require funds to disclose the dollar cost of a $10,000 investment, based on the fund's actual expenses and return, "is a significant step toward demystifying the expenses paid by fund owners.").

³² See 68 Fed. Reg. at 168 (stating that, "[w]hile some have advocated that this information should be provided on an individualized basis in shareholder account statements, our proposals are intended to strike an appropriate balance between investors' need for this information and the costs and burdens that would be associated with providing this information on an individualized basis.").

³³ As noted in the Proposing Release, later that year, the Commission staff issued its own report on mutual fund fees and expenses which concluded, after considering the recommendations in the GAO report, that "disclosure of the dollar amount of fees paid for a preset investment amount would likely have the most favorable trade-off between costs and benefits." Id. at 163 (citation omitted).

³⁴ Id. at 169.

³⁵ See Investment Company Institute, 2002 Mutual Fund Fact Book, at 33.

³⁶ ICI Survey on GAO Report on Mutual Fund Fees (January 31, 2001). The survey was conducted with the assistance of an industry task force and PricewaterhouseCoopers LLP. Respondents to the survey included 39 mutual fund complexes representing approximately 77 percent of total industry net assets as of June 30, 2000, nine national, regional and clearing broker-dealers, three major independent transfer and shareholder servicing agents, and four financial planning firms. A copy of the survey is attached as Appendix A to this letter.

³⁷ The results of the survey indicated that compliance with the GAO recommendation would involve four major cost elements, including: (1) enhancements to data processing systems, such as additional computing and data storage capacity, programming changes to enable computation of the required numbers, and system enhancements to permit the electronic communication of the information to intermediary organizations; (2) modifications to investor communications systems and media, including modifications to quarterly statement formats, to websites and telephone systems used to communicate directly with investors and to on-line account systems used by registered representatives; (3) development and documentation of new policies and procedures in fund accounting, transfer agent and financial intermediary operations to ensure that expense information is correctly calculated and provide for quality control of new tasks; and (4) employee training programs and customer support.

³⁸ The survey also estimated the costs of two other methods of account statement disclosure: (1) providing an estimate of fund operating expenses attributable to each investor; and (2) disclosing the actual dollar amount of fund expenses per thousand dollars invested in the fund. The aggregate costs that the entities surveyed would incur to implement these methods were estimated to be $189.4 million (initial costs)/$58.3 million (annual ongoing costs) and $141.3 million (initial costs)/$45.5 million (annual ongoing costs), respectively.

³⁹ 68 Fed. Reg. at 176 (citation omitted). See also id. at n. 80 (noting that assuming a cost of $1 per shareholder account to provide personalized disclosure in account statements, industry-wide costs would be approximately $248 million).

⁴⁰ Account statement disclosure also would single out fund expenses from other equally important information about funds and might inappropriately suggest that expenses are the only item investors should consider. By contrast, providing the disclosure in shareholder reports with other information about an investment in the fund during the period covered, as the Commission has proposed, would substantially mitigate this potential problem.

⁴¹ See 68 Fed. Reg. at 168 ("The numbers that we are proposing be disclosed in mutual fund shareholder reports are intended to provide information to investors about actual current period expenses.")

⁴² Specifically, Item 3 of Form N-1A requires funds to include with the fee table a hypothetical example designed to show in dollar terms the aggregate expenses that an investor could expect to pay over 1-, 3-, 5-, and 10-year periods, assuming a $10,000 investment, no changes in fund expenses, and a 5 percent annual return.

⁴³ See, e.g., Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, Securities and Exchange Commission, dated August 11, 1998, at 4.

⁴⁴ See SEC Release Nos. 34-47262; IC-25914 (January 27, 2003), 68 Fed. Reg. 5348 (February 3, 2003).

⁴⁵ See Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Mr. Jonathan G. Katz, Secretary, Securities and Exchange Commission, dated October 16, 2002 (noting that "[r]equiring the MDFP to be certified almost certainly would result in a scaled back, less robust discussion of information that investors find useful.").

⁴⁶ 68 Fed. Reg. at 170.

⁴⁷ 68 Fed. Reg. at 166.

⁴⁸ See Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Paul F. Roye, Director, Division of Investment Management, Securities and Exchange Commission, dated July 17, 2001.

⁴⁹ Indeed, until December 1981, funds were required to file information about acquisitions and dispositions of portfolio securities with the Commission on a calendar quarterly basis on Form N-1Q. See SEC Release Nos. 33-6366, 34-18337, IC-12107 (December 16, 1981) ("N-1Q Release"). The Commission eliminated this requirement after concluding that "the limited benefit to the public of quarterly transaction reporting by investment companies is outweighed by the costs of such reporting." N-1Q Release at 26. More specifically, the Commission determined that the information was no longer required to aid the Commission in its regulatory responsibilities or to collect information for studies, and concluded that sufficient information was available to interested persons through reports on Form 13F and other portfolio disclosure requirements applicable to investment companies. Id. at 25-26.

⁵⁰ The survey was conducted in August 2001 by interviewing 500 investors owning stock mutual funds outside of employer-sponsored retirement plans. A summary of the survey results is set forth in Appendix B to this letter.

⁵¹ For example, 72 percent of those responding indicated that they were not interested in receiving quarterly portfolio holdings information, even if the information is free of charge. In addition, only 13 percent indicated that that would be willing to pay for quarterly portfolio disclosure. The vast majority of respondents (84 percent) indicated that they would be concerned about investors outside their stock funds having sufficient information to anticipate the timing of the fund managers' purchases and sales of specific stocks.

⁵² 68 Fed. Reg. at 174.

⁵³ On a related point on which the Commission has requested comments, we would oppose requiring that the proposed summary portfolio schedule and/or the complete portfolio schedule identify securities acquired within a designated number of days before the end of the reporting period. This type of disclosure would be confusing to investors and could lead to misimpressions about the propriety of fund acquisitions of securities.

⁵⁴ The cost/benefit analysis in the Proposing Release suggests that mandating quarterly portfolio disclosure may not significantly increase the likelihood of front running of mutual fund portfolios. See 68 Fed. Reg. at 175-76. According to the cost/benefit analysis, for increased front running to occur, eight conditions must hold simultaneously and these conditions may rarely be met. This conclusion is based on the Commission's estimate in footnote 107 of the Proposing Release that essentially all mutual funds can unwind a position in any one portfolio security within an average of nine days. No information on the basis for this estimate is provided. However, even if this claim is true on average, based on our own analysis and our discussions with members, we believe that the estimate significantly understates the time within which some funds-particularly larger funds that have concentrated portfolios, hold more of particular issues or hold thinly-traded stocks-can buy or sell certain securities at reasonable cost. Moreover, the Commission's cost/benefit analysis ignores the basic fact that any additional information about fund portfolio holdings will facilitate front running that is already occurring. The better market participants are able to anticipate fund trades through publicly available information, the easier and more profitable front running will be. Requiring more frequent disclosure of fund portfolio holdings would add to the mix of information that is currently available about the individual portfolio securities of mutual funds (including information from reports filed by institutional investment managers on Form 13F, as discussed further below) and thus can be expected to compound the risk of front running of fund trades.

⁵⁵ The Commission's cost/benefit analysis seems to be of the view that the costs of free riding resulting from requiring quarterly portfolio holdings disclosure are likely to be insignificant. See id. at 176. This is based partly on the premise, expressed in some academic research, that it is difficult to consistently identify skilled fund managers, as well as on the view expressed in the Proposing Release (at least implicitly) that information about fund trades must become stale or uninformative within 2 to 5 months after trades are initiated. In response to the Commission's request for comment on its analysis, the Institute notes that recent research indicates that fund managers are able to identify mispriced securities through research, that the benefits of that ability accrue to mutual funds and their investors through higher-than-average returns over a period of time, and that this period of time may be lengthy, from between 12 to 18 months to as long as six years. See R. Wermers, "Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses," Journal of Finance, 55, 2000, at 1658 (supporting the proposition that mutual fund managers can identify mispriced securities); Hsiu-Lang Chen, Narasimhan Jegadeesh, and Russ Wermers, "The Value of Active Mutual Fund Management: An Examination of the Stockholdings and Trades of Fund Managers," Journal of Financial and Quantitative Analysis, 35 (2000), at 353-55 (finding that excess returns on the stocks in mutual fund portfolios persist); and Melvyn Teo and Sung-Jun Woo (November 2001, working paper, Department of Economics, Harvard University) (finding that "differences in style-adjusted returns persist for up to six years" (emphasis added) and that that "is suggestive of managerial stock-picking ability."). Moreover, other recent research has indicated that it is possible to use the information from semi-annual disclosure of fund portfolio holdings to free ride on the research of actively managed mutual funds, by mimicking ("copy-catting") their portfolios, and garnering a higher return because the funds' research is obtained for free through their semi-annual reports. See Myers, Poterba, Shackelford, and Shoven, "Copycat Funds: Information Disclosure Regulation and the Returns to Active Management in the Mutual Fund Industry," MIT Department of Economics working paper 02-04, October 2001. In short, the evidence is at least as strong that free riding based on fund portfolio holdings disclosure can be achieved, is profitable, and will be facilitated by more frequent portfolio disclosure.

⁵⁶ Russ Wermers, "The Potential Effects of More Frequent Portfolio Disclosure on Mutual Fund Performance," Perspective, Vol. 7, No. 3, June 2001, Investment Company Institute ("Wermers Study") at 1. As discussed in our 2001 submission, these concerns are not merely theoretical. In a scan of financial websites on the Internet, the Institute uncovered several examples of services that claim to provide clients with the ability to "piggyback" off of fund research and investment strategies. The gains for those who would exploit fund portfolio holdings information will come at the direct expense of fund shareholders.

⁵⁷ Section 13(f) of the Exchange Act and Rule 13f-1 thereunder generally require institutional investment managers that manage more than $100 million in certain equity securities to file reports on Form 13F with the Commission within 45 days after the end of each calendar quarter. The instructions to Form 13F include instructions for requesting confidential treatment of information required to be reported.

⁵⁸ See note 1 to Rule 12-12 of Regulation S-X (see Section I.A.6, supra p. 6). In this regard, we note that the utility of the 5 percent basket of miscellaneous securities is somewhat limited because, for example, it only applies to positions that have not previously been reported and thus would not protect a fund against prematurely revealing the disposition of a security. Confidential treatment should be available whether a fund uses a summary portfolio schedule or includes its complete portfolio in its shareholder reports.

⁵⁹ See Investment Company Institute, Proposals to Improve Investment Company Regulation (May 1, 2002) at 61-64; Letter from Craig S. Tyle, General Counsel, Investment Company Institute, to Paul F. Roye, Director, Division of Investment Management, Securities and Exchange Commission, dated July 17, 2001, at 7-8.

⁶⁰ The original purposes of Section 13(f) included, for example, creating a central repository of information about the investment activities of institutional investment managers in order to allow regulatory agencies to analyze the influence and impact of those managers on the securities markets as well as the public policy implications of their investment activities. See Exchange Act Release No. 14852 (June 15, 1978) at 5.

⁶¹ For example, as noted above, when filing 13F reports, investment managers are permitted to request confidential treatment of certain types of information, including information that would reveal an investment manager's program of acquisition or disposition that is ongoing both at the end of a reporting period and at the time of filing the Form 13F. As discussed above, we believe that if funds will be required to disclose their portfolio holdings on a quarterly basis, the Commission should adopt a similar confidential treatment provision.

⁶² The Commission's Chief Economist, in a recent publication, noted that "[t]he information [in 13F reports] is particularly useful when the large trader is a seller whose investment policy prohibits short sales." Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners, Oxford University Press, 2003, at 326. This would often be the case for a large mutual fund.

⁶³ Even if the Commission makes this change, it is important to maintain the provisions for requesting confidential treatment of information in 13F reports, especially if quarterly disclosure of fund portfolio holdings is required. As discussed above, the potential for outsiders to use portfolio holdings information to the detriment of fund shareholders would be reduced but not eliminated by a 60-day delay in disclosure of the information. Therefore, the need to request confidential treatment of 13F reports could still arise and the opportunity to do so should remain available.

⁶⁴ 68 Fed. Reg. at 168.

⁶⁵ Id. at 165.

⁶⁶ Id. at 170.