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What's Wrong with Forced Disclosure?

Mises Daily: Thursday, September 20, 2001 by

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Under prodding from agitators and activists, the Securities and Exchange Commission is considering a proposal that would reduce the investment performance of mutual funds. If adopted, the measure would impose harsher disclosure requirements on portfolio managers under federal law.  

Instead of reporting their holdings semiannually, as is current practice, mutual funds would be forced to publish their holdings more frequently-perhaps monthly. Opening up mutual fund investment strategies to such frequent public disclosure would degrade proprietary research and diminish a fund's performance against both benchmark indexes and competitors.

The scrutiny over mutual fund disclosure practices comes amidst a flurry of rules, investigations, and regulatory pressure being applied to the broader securities industry. The SEC imposed Regulation FD last year and has followed up with scrutiny over the naming of mutual funds.

The latest measure, if adopted, is meant to help individual investors track their mutual fund's holdings and to evaluate fund performance. It is also intended to deter portfolio "window dressing," in which fund managers sometimes alter their holdings just before a quarter's end. However, the rule would do more harm than good for the investors it is meant to help.

An obvious result of a forced disclosure rule will be free-riding. When the SEC receives mutual fund industry disclosures, it posts the holdings data electronically on its EDGAR system. Others, including competitors, are then able to duplicate a popular mutual fund's investments. Using the frequently published data, such individuals could benefit from a good portfolio manager's research and expertise without paying for it.

There are even services on the Internet that promise to sell information about fund holdings, distributing this information widely. In other contexts, like software, this appropriation of work would be considered theft of intellectual property. When it's mandated by a federal agency, it's called regulation in the public interest.

Another drawback to forced disclosure is a related phenomenon called "front-running." Sophisticated market players, such as hedge funds and Wall Street traders, can buy or sell stocks in advance of a large mutual fund. A disclosure rule that reveals mutual fund holdings on a frequent basis would make this harmful practice easier. It would reveal the fund's thinking and strategy and allow outsiders to anticipate its future trades. Front-running means that mutual funds must buy stocks at higher prices-or sell at lower prices-than they otherwise would.

Front-running is illustrated by the following simple example. Suppose a mutual fund manager uses a complex quantitative screen based on a proprietary model developed in-house. Opportunistic observers can use frequent portfolio holdings disclosures to replicate the fund manager's model and approximate what large trades the fund must make to implement its strategy on a continual basis. Thus, outsiders can buy (or short-sell) stocks right before the mutual fund must make its own transactions, reaping immediate short-term trading profits at the expense of the fund and its shareholders. This lowers the total return a typical investor receives from mutual fund investments.

Exposing mutual fund holdings on a frequent basis erodes the secrecy and confidentiality a fund manager must have in order to effectively implement a stock market investment strategy. If significant market players like mutual funds must disclose their intentions to the world, the markets lose price continuity, a vital component of liquidity.

Simply put, the market is less liquid if a fund manager cannot reasonably expect to buy or sell a security at a price close to the prices for previous transactions in the same security.

Mutual fund shareholders pay management fees so that professional portfolio managers can perform their duties. Such fees are for naught if regulators step in and reveal to the entire world the fund manager's portfolio strategy. Those who would force more stringent disclosure rules on the mutual fund industry are no friends of the shareholder.

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James M. Sheehan is an adjunct scholar of the Competitive Enterprise Institute.  You may reach him at MAIL.  See also his Free Market Archive.