Fund advisers will not get a break from fund boards this fall, even if the most contentious presidential election in decades leaves little room for discussion of anything else.
No matter how the election turns out – or how anyone feels about it – fund boards will be expecting detailed reports about how fund advisers went through the process of reevaluating every potentially misleading word in shareholder reports, regulatory filings and other documents that fund complexes pump out in high volume near the end of every year.
“Growth,” “value” and other optimistic but ill-defined words will carry more risk of enforcement action during the fourth quarter than they did in September, when changes to the SEC’s names rule went into effect. The rule increased regulatory scrutiny of fund names and required funds to define how they apply certain terms.
Advisers are likely to have to explain to both directors and SEC examiners how they define words such as “growth,” and “value,” which both sound optimistic but are difficult to precisely define.
They will also have to show that they’ve reviewed their portfolios to make sure at least 80% of the fund’s holdings match the strategies described in words that are now in play after decades spent stuffed safely into the boilerplate of fund-complex reports and marketing materials, according to lawyers advising both fund complexes and their boards.
Definition difficulties
“Analysis has to be conducted, policy decisions have to be made, et cetera,” she said. “I think what boards need to be doing is to make sure that that is occurring, first and foremost,” according to Molly Moynihan, a partner at Perkins Coie.
The implementation work will mainly take place within advisers’ legal, compliance, risk, and portfolio management departments, but boards should make sure they stay updated on what is taking place behind the scenes,
Most fund advisers have until December 2025 to complete the rule implementation, while fund groups with less than $1bn in assets have until June 2025.
Plenty have already leaped into action, however, to get an early start on textual analysis and decisions about how whether to change the descriptions or the held assets of funds at risk of failing the 80% strategy rule.
“There’s certainly time before the compliance date, but there’s definitely a sense of urgency among firms to try to develop tests in time to ensure they can implement them from a compliance perspective,” said Ryan Brizek, a partner at Simpson Thacher.
The more funds a complex has, the larger the implementation challenge, which could prompt them to act much earlier than advisers at small complexes that could get away with a slower start due to their longer deadlines and lighter workloads.
The names rule is far from the only set of changes funds and fund boards have to deal with, however, no matter what their size according to Barry Benjamin, an independent trustee on the board of the nine-fund Morningstar Funds Trust. Morningstar trustees talked about the names rule during their last meeting, but spent much more time on the conclusion of the tailored shareholder-report rule implementation, he said.
“For us only having the nine [funds, the names rule is] something I can think we can work on toward the latter part of this year,” said Benjamin, who expects to hear more from the funds’ adviser about names-rule implementation work during the board’s fall meeting.
Even fund groups that believe they have plenty of time to adjust should get rolling soon on their implementation of the names rule, according to Gwendolyn Williamson, a partner at Faegre Drinker.
Analysis and examination of fund names is likely to take a while, and updating the language of fund strategies with the SEC could take months longer to process, she said.
“I think shops of any size, if they haven’t at least started to map out to have a good sense of what they’re going to do, I would press that the CCO and the legal group on that,” Williamson said. “I would want to know for sure by this next fourth-quarter board meeting that the process had started.”
Names may be easier than 80% tests
Analyzing and defining the language in their marketing materials will definitely take some time, but figuring out how to create tests that would show that language matches the strategy underlying 80% of the investment decisions of a particular fund could be a lot more complicated, Brizek said. The need to focus definitions involving ESG and other thematic strategies adds even more complications.
“Most fund firms are still developing their final recommendations on how 80% tests would need to change in connection with the names rule and how to do that,” Brizek said.
Even simple-sounding definitions could be big problems, however, according to other experts, because the rule itself offers few definitions and almost no explanation about how to test for compliance.
“I would argue that the biggest lift is for long-only equity managers because words like ‘growth,’ ‘value,’ ‘momentum’ are captured by the rule and are very hard to define,” Brizek said. “The [final rule] release doesn’t really give any guidance on that, and it is not as easy to define as it may seem.”
Many fund groups have begun this analysis, but none have finished it yet, according to Williamson, who predicted the process will be a long and difficult one for large fund complexes with diverse lineups.
“If you’ve got 200 funds, and you’ve got a large-, a small-, and a mid-cap growth and a large-, a small-, and a mid-cap value, six different types of emerging markets funds, you’ve got a bunch of different geographically designated funds, you’ve got a bunch with ESG or ESG-like words in there, for example, the more likely it is that you’ve got more funds that are [covered] by the expanded rule,” Williamson said.
Boards wait for adviser recommendations
After a fund adviser has decided on the criteria and test it wants to attach to each fund marketing term, it will need to identify which of its funds do not comply and decide how to bring them into compliance.
Depending on the situation, this may involve a combination of name changes, strategy changes, or even mergers and liquidations.
Because fund names generally fall under the adviser’s purview as part of fund marketing, it seems unlikely fund boards would find any name-related proposals so objectionable as to elicit an intervention, Moynihan said.
Changes to names and strategies could create unexpected effects, however, which is why trustees should plan to spend extra time making sure the adviser’s recommendations make sense once the analyses reach the board, she said.
“I do tend to think that this is something that is really in the adviser’s prerogative. I don’t see a fund board saying no, we want to keep such and such name,” Moynihan said. “But I think that the fund board should be very attentive to consistency and approach, to ensure that ultimately the adviser is fully in compliance with the rule.”
Most board members and members of board counsel interviewed said they expect to receive the results of their advisers’ reviews and possibly formal proposals about name or strategy changes late this year or early next.
“Toward the beginning of next year, I think most fund firms are going to plan to have their proposals finalized,” Brizek said.
While there’s not much for trustees to review or approve until then, boards should make sure their fund managers are updating them on their progress.
“Are any of our current fund names implicated by the new names rule that were not implicated under the prior names rule?” Brizek said.
“If so, what 80% policy are you considering implementing, and/or how are you planning to amend our funds’ existing 80% policy, if at all,” Brizek asked. “And why?”
