SEC Risk Alert of October 26, 2021
Observations from Examinations in the Registered Investment Company Initiatives*
All notes below are quoted from the SEC Risk Alert
The Division of Examinations (the “Division”) conducted a series of examinations that focused on mutual funds and exchange-traded funds (collectively, “funds”) to assess industry practices and regulatory compliance in certain areas that may have an impact on retail investors (“RIC Initiatives” or “Initiatives”).
The RIC Initiatives focused on funds and/or their investment advisers (“advisers”) that fell into one or more of the following six categories:
(1) index funds that track custom-built indexes;
(2) smaller ETFs and/or ETFs with little secondary market trading volume;
(3) mutual funds with higher allocations to certain securitized investments;
(4) mutual funds with aberrational underperformance relative to their peer groups;
(5) mutual funds managed by advisers that are relatively new to managing such funds; and
(6) advisers that provide advice to both mutual funds and private funds, both of which have similar strategies and/or are managed by the same portfolio managers.
This Risk Alert provides observations made by Division staff during examinations conducted under the RIC Initiatives, including examinations of more than 50 fund complexes – covering more than 200 funds and/or series of funds – and nearly 100 advisers.
Focus of Initiatives
The scope of the examinations and focus areas selected for review were tailored to address the business practices, risks, and conflicts applicable to each of the six categories. However, across all examinations the staff generally assessed:
• Effectiveness of the compliance policies and procedures of the funds and their advisers to address certain risks – particularly in the areas of disclosures, portfolio management compliance, and conflicts of interest – and the efficacy of the oversight of funds’ compliance programs by funds’ boards.2
• Disclosures by the funds to investors in their prospectuses and other filings and shareholder communications, and by advisers to the funds’ boards, regarding risks and conflicts in the highlighted areas.3
• Fund governance practices, particularly as they relate to the deliberative processes utilized by funds and funds’ boards when exercising oversight of funds’ compliance programs and assessing the practices and controls related to risks in the highlighted areas.
Staff Observations from the Examinations
A. Compliance Program
Below are examples of deficiencies or weaknesses observed by the staff related to funds’ and their advisers’ compliance programs for portfolio management and other business practices, and board oversight of funds’ compliance programs.
• The staff observed funds and their advisers that did not establish, maintain, update, follow and/or appropriately tailor their compliance programs to address various business practices, including portfolio management, valuation, trading, conflicts of interest, fees and expenses, and advertising.
Examples include inadequate policies and procedures in the following areas
Compliance Oversight of Investments and Portfolios
o Monitoring for portfolio management compliance, including monitoring compliance requirements regarding trade aggregation, trade allocation and best execution, and senior securities and asset segregation.
o Monitoring for adherence to each fund’s specific investment restrictions (e.g., investment concentration restrictions, limitations on investments in alternative investments, and/or restrictions on lower-rated securities).
o Monitoring for the specific risks associated with each fund’s investments such as asset classes that present certain operational or other risks.
o Monitoring portfolios for compliance with the “Fund Names Rule,” as applicable.
o Addressing the administration of each fund’s liquidity risk management program (“LRMP”) and providing appropriate oversight of third-party vendors providing liquidity classifications of holdings for purposes of the funds’ LRMP.
o Providing appropriate oversight of the viability of smaller and/or thinly traded ETFs and oversight of their liquidation, as applicable, including communications with their shareholders.
Compliance Oversight of Valuation
o Maintaining an adequate compliance program for valuation of portfolio securities, including processes, controls, or both, that provide for due diligence and oversight of pricing vendors that provide evaluated prices for portfolio holdings for purposes of calculating the funds’ daily net asset values.8
o Maintaining appropriate policies, procedures and/or controls for valuation of portfolio securities, including provisions that address potential conflicts and issues, such as where portfolio managers are permitted to provide input – as voting members of the valuation committee – on prices of securities in funds they managed.
Compliance Oversight of Trading Practices
o Addressing appropriate trade allocation among client accounts so that all clients are treated fairly, including instances where trades for fund clients are aggregated with trades for other client accounts, including sub-advised funds, wrap accounts, and other non-wrap client accounts.
o Preventing prohibited principal transactions with affiliates, prohibited joint transactions with affiliates, or both.
o Identifying cross trades and preventing related violations of the legal requirements for cross trading and principal trading under the Advisers Act and the IC Act.
o Addressing sharing of soft dollar commissions among clients to assess whether any client is disadvantaged.
Compliance Oversight of Conflicts of Interest
o Addressing advisers’ conflicts of interest with funds and their service providers, such as certain “dual capacity” instances where the adviser to an index fund also acts as the index provider.
o Reviewing index providers and the services they provide for, among other things: (1) conflicts of interest with advisers, such as when they share personnel, are affiliated, and/or have business arrangements (e.g., marketing support payments by index providers to advisers and/or revenue sharing payments by advisers to index providers); and (2) the sharing, or the potential misuse, of material non-public information
Compliance Oversight of Fees and Expenses
o Monitoring allocation of expenses between funds and their advisers, subject to any fee waivers by the adviser.
O Reviewing fee calculations for any inconsistencies between a fund’s contractual expense limitation and its disclosures regarding expenses included in operating expenses, subject to the expense cap.
Compliance Oversight of Fund Advertisements and Sales Literature
o Reviewing and filing fund advertisements and sales literature, including review of fee and expense disclosures for whether they are fair, balanced and not misleading within the context in which they are made,11 and, as applicable, the presentation of back-tested index returns (e.g., the characteristics of back-tested index returns when compared to a fund’s actual returns).
o Reviewing affiliated index providers’ websites – accessible through hyperlinks in the statements of additional information (“SAIs”) of self-indexing funds – to assess whether the websites may be deemed fund sales literature that should be filed with the Commission or FINRA.12
• The staff observed issues with funds’ policies and procedures for their boards’ oversight of the funds’ compliance programs. For example, the staff observed funds that did not:
o Have appropriate policies, procedures and processes for monitoring and reporting to their boards with accurate information, such as information regarding:
(1) fees paid by the funds to financial intermediaries and other service providers for providing shareholder services;
(2) the type of services provided by service providers;
(3) pricing exceptions under the funds’ valuation policies and procedures;
(4) adviser’s recommendation whether a fund’s liquidation may be in the best interests of the fund and its shareholders;13 and
(5) portfolio compliance with senior securities and asset coverage requirements.14
o Provide appropriate processes as part of the respective fund board’s annual review and approval of the fund’s investment advisory agreement under Section 15(c) of the IC Act
regarding the board’s considerations as to whether the adviser has any financial condition that is reasonably likely to impair its ability to meet its contractual commitments to clients.15
o Complete required annual reviews of the funds’ compliance programs that address the adequacy of policies and procedures and effectiveness of their implementation.16
o Ensure that the annual report from the respective fund’s chief compliance officer addressed the operation of the policies and procedures of the fund’s adviser,17 including whether the adviser had policies and procedures in specific risk areas.
o Adopt or maintain appropriate policies and procedures for the funds’ boards to exercise appropriate oversight in instances where the funds’ delegated responsibilities to their advisers that were not reflected in the advisers’ compliance programs.18
B. Disclosure to Investors
Below are examples of deficiencies or weaknesses observed by the staff related to the funds’ disclosures to investors in fund filings, advertisements, sales literature and/or other shareholder communications.
• The staff observed funds had inaccurate, incomplete and/or omitted disclosures in their filings.
o Omitted disclosures regarding:
(1) certain principal investment strategies and/or risks of investing in the funds;
2) potential conflicts associated with allocating investment opportunities among overlapping investment strategies and
(3) change in the broad-based indexes used for comparison of funds’ performance.
o Inconsistent and/or inaccurate disclosure concerning the funds’ net assets and net expense ratios, contractual expense limitations, and/or operating expenses subject to the contractual expense limitation.
o Did not disclose in the funds’ SAIs required information concerning standing committees of a fund’s board and accurate information regarding the number of accounts and total assets managed by the portfolio managers within each of the required categories.
• The staff observed funds that had inaccurate, incomplete, and/or omitted disclosures on a variety of advertising and sales literature-related topics, such as:
(1) investment strategies and portfolio holdings;
(2) the differences in investment objective between predecessor and successor funds;
(3) inception dates;
(4) funds’ expenses, contractual expense limitations, and/or expense ratios;
(5) average total returns and/or gross expenses and net expenses;23
(6) performance information not disclosed with the required legends;24
(7) awards received for fund performance;25
(8) weighting of index constituents in the benchmark index;
(9) methodologies for calculating the performance of the benchmark index;
(10) differences in holdings, risk, and volatility between the broad-based and bespoke indexes used for performance comparisons; and/or
(11) composition of index used for performance comparisons.
C. Staff Observations Regarding Compliance and Disclosure Practices
The staff observed various practices with respect to funds’ and their advisers’ compliance programs, the boards’ oversight of funds’ compliance programs, and disclosure practices that funds and their advisers may find helpful in their compliance oversight practices. Below is a sampled list of practices that may assist funds and their advisers in designing and implementing their compliance programs.
• Certain funds and their advisers adopted and implemented compliance programs that provided for the following:
o Review of compliance policies and procedures for consistency with practices (e.g., funds reviewed their advisers’ compliance manuals for specific policies and procedures addressing various risk areas for which the funds had delegated responsibility to their advisers).
o Conducting periodic testing and reviews for compliance with disclosures (e.g., review whether funds are complying with their stated investment objectives, investment strategies, restrictions, and other disclosures) and assess the effectiveness of compliance policies and procedures in addressing conflicts of interests (e.g., review trade and expense allocation policies and procedures in light of potential conflicts that may exist among the various types of accounts managed by the adviser).
o Ensuring compliance programs adequately address the oversight of key vendors, such as pricing vendors (e.g., written pricing vendor oversight processes include reviewing variance reports on stale or outlier prices and price challenges).
o Adopting and implementing policies and procedures to address: (1) compliance with applicable regulations (e.g., to identify cross trades, where applicable, and prevent related violations); (2) compliance with the terms and conditions of applicable exemptive orders and any disclosures required to be made under the order; and (3) undisclosed conflicts of interest, including potential conflicts between funds and/or advisers and their affiliated service providers.
• Certain funds’ boards provided oversight of funds’ compliance programs by assessing whether:
o The information provided to the board was accurate, including whether funds’ and their advisers were accurately disclosing to the boards: (1) funds’ fees, expenses and performance, and (2) funds’ investment strategies, any changes to the strategies, and the risks associated with the respective strategies.
o The funds were adhering to their processes for board reporting, including an annual review of the adequacy of the funds’ compliance program and effectiveness of their implementation.
• Certain funds adopted and implemented policies and procedures concerning disclosure, such as those that required:
o Review and amendment of disclosures in funds’ prospectuses, SAIs, shareholder reports or other investor communications consistent with the funds’ investments and investment policies and restrictions.
o Amendment of disclosures for consistency with actions taken by the funds’ boards, as applicable.
o Update of funds’ website disclosures concurrently with new or amended disclosures in funds’ prospectuses, SAIs, shareholder reports or other client communications.
o Review and testing of fees and expenses disclosed in funds’ prospectuses, SAIs, shareholder reports or other client communications for accuracy and completeness of presentation.
o Review and testing of funds’ performance advertising for accuracy and appropriateness of presentation and applicable disclosures.