The SEC’s Division of Investment Management released new guidance this week to remind “mutual funds, exchange traded funds, and other registered investment companies of the importance to investors of full and accurate information about fund risks, including risks that arise as a result of changing market conditions.” Specifically, the guidance notes that “funds should review their risk disclosures on an ongoing basis and consider whether these disclosures remain adequate in light of current conditions.”
The staff reminds funds that risk is not a static concept, it “changes in response to market conditions, and different risks may be heightened or lessened at different points in time.” Accordingly, the guidance recommends that funds should monitor market conditions and the resulting impact on fund risk, determine whether fund risks have been adequately disclosed to investors as market conditions change, and disclose any material changes in the fund’s risks to investors. Additionally, the guidance notes that many boards look to adviser to report on the adviser’s process for preparing disclosure materials. The staff recommends that advisers “should consider providing information to the fund board on the steps taken by the adviser to evaluate fund risk disclosures and consider whether changes are appropriate.”
The guidance offers examples of changing market conditions and updated disclosures that they have observed, including the effect that the end of quantitative easing and increasing federal funds rates may have on fixed income funds. The staff observed that some funds have alerted investors to an increase in interest rate risk on their websites or in the Management’s Discussion of Fund Performance and Presidents’ letters, noting that current interest rates are at historical lows and that shifts in government policy may affect interest rates and cause a decrease in value of portfolio assets.
Related to interest rate risk, the staff notes that an increase in interest rates could drive volatility and redemptions, creating liquidity risk for funds. The guidance points to disclosure by some funds noting that they may need to liquidate assets in a manner that could reduce the fund’s returns and that a reduction in market-making activities by dealers could also affect liquidity. Lastly, the staff notes that some funds have disclosed that they may face increased duration risk due to an increase in sensitivity to interest rate changes for longer-term securities and that some funds have even included numerical examples as illustrations.
The guidance also addresses disclosures for funds with investments in Puerto Rican debt based on recent failures of the local government to make scheduled bond payments. The guidance notes that a disclosure that a fund invests in Puerto Rican debt can alert investors to the associated potential default risk, particularly relevant in the case of “single-state” funds because Puerto Rican debt is tax free in all states under federal law. Additionally, some funds have disclosed that budget shortfalls in Puerto Rico and credit downgrades of local government debt and the associated impact to liquidity present risks to investors.