Best practices in Fund Disclosures

By: Satish Betadpur, CFA, Investor, Former MD, TIAA-CREF

Mutual Fund (MF) disclosures are critical since they help investors decision making. There is no uniformity in fund disclosures. The asset management companies (AMC) globally have a lot of leeway on what they disclose barring a few disclosures that are mandated by the local regulators. 

Globally, the funds disclose a lot of information that can be daunting for a layman investor. Instead of dumping a lot of information, funds should disclose critical information that can help in simplifying due diligence. Excessive information can obfuscate rather than enlighten. In India, were mutual fund penetration is low and investor knowledge is shaped by negative incidents, it is important that the funds proactively disclose relevant and appropriate information in an easy to use format. While I have used equity funds as an example in this article, the same concepts work for bond or hybrid funds.

I have divided the fund disclosure into two categories. 1. Fund disclosures to current unit holders 2. Fund disclosures to general public. In general, the disclosure to the general public should be a substantially similar to the disclosure to the current holders except for the specific number unit holdings and the cost of the holdings. The Indian markets regulator, Securities and Exchange Board of India (SEBI) has published guidelines on fund disclosure to account holders. The guidelines are quite comprehensive. I have highlighted the key points of SEBI’s mandatory disclosure requirement.

SEBI requires a Consolidated Account Statement (CAS) issued to investors. The CAS provides information in terms of name of scheme/s where the investor has invested, number of units held and its market value, the total purchase value / cost of investment in each scheme. SEBI also mandates that the fund discloses commission paid to distributors, expense ratios, fund manager details, fund holdings and sector weightings. Also, the fund is required to have a dashboard on their website providing performance and key disclosures, such as the fund’s Asset Under Management (AUM), investment objective, expense ratios, portfolio details, scheme’s past performance.

While these SEBI mandated information is useful, is it sufficient for a mutual fund investor to do a reasonable due diligence before making the buy/sell/hold decision? The most important reason to pick a MF over another MF is the ability of the fund manager to generate returns in excess of a benchmark while taking minimal risk. The fund disclosures should provide investors the ability to fathom whether a fund manager is indeed adding value to the fund by beating the benchmark with minimal risk.

The simplest way to check if the fund manager is beating the index, is to check if the fund returns are consistently above the benchmark over a certain period (3, 5 or 10 years). This information is SEBI mandated and thus, available. Many investors also tend to look at portfolio holdings to see if the fund is investing in ‘good’ stocks. This has led to a phenomenon of portfolio dressing where at the end of the fiscal year, the fund sells all its ‘losing’ stocks and loads the fund up with stocks that outperformed in the past year. The same phenomenon can happen in Sector holdings. This clearly misinforms the investors of the stocks or sectors that the fund bet on. Even if the fund manager does not indulge in portfolio dressing, the holdings statements released by funds are not very useful. As an example, let’s look at table below which shows the holdings of Janus Research fund. In the holdings table, Apple Inc is the second largest holding in the fund at 3.71%. Looking at this, an investor may believe that the fund is betting on Apple. In-fact, the exact opposite is true. The index weighting of Apple Inc is 5.32%. Clearly, the fund is underweight Apple Inc. Thus, the holdings table is not useful unless the index weights of the stocks are shown. But this is rarely done globally or in India.

Investors should not only focus on returns. It is important to understand the risk taken to achieve the return. A few highly respected global fund houses such as The Capital Group, report multiple risk measures such as Sharpe Ratio, Standard Deviation, Beta, Capture Ratio etc. Disclosing risk measures is not common either in India or globally. Some of these measures are highly technical and may require some understanding of finance before they can be used. 

Fortunately the risk measure, Capture Ratio is intuitive and easily understandable risk metric that the funds should report. A Capture Ratio is a risk measure that gives an Upside/Downside ratio. Investors would like to invest in funds that lose less than the market in a downturn. Simply said, such funds are less volatile. If the fund loses only 75% as much as the market during a market sell-off, then the fund is said to have a Downside Capture of 75%. Similarly on the upside, if the fund captures 90% of the market rally, the Upside Capture is 90%. Such a fund has a Capture Ratio (Upside/Downside) of 90/75. Studies have shown, that a Capture Ratio of 90/70 have significantly outperformed the benchmarks.

Intrinsically, lower downside capture ratio means that the fund has lost less of its assets on the downside and thus, has more assets that can be put to work in a market upside. For a fund manager to get a good capture ratio, requires skill. The fund manager needs to build a portfolio of companies that are of high quality – good balance sheets & cash flows and wide economic moat. Clearly, this is what an investor is looking for while selecting a fund.

Another very important disclosure that would immensely help in evaluating a fund is a fund commentary written by the fund manager. Globally and in India, fund manager commentaries are di  rigueur but unfortunately, the commentary generally focusses on macro-economic analysis. A good commentary should include details on stocks that added value to the fund and stocks detracted value of the fund. In such a note, the fund manager can give his/her rational for owning a particular stock that added value or lost value. The fund also can give a succinct explanation as to why a stock did not react the way he or she expected it to behave. As an example, I have highlighted a few sentences from the Janus Research Fund. These notes are clear and gives the investor a good insight into the fund’s investment methodology.

 “Detracting most from relative returns were the Fund’s health care and technology holdings. Several of the top individual detractors came from the health care space. Biotechnology company Regeneron Pharmaceuticals was among the Fund’s largest underperformers. The company’s stock declined precipitously during January before stabilizing. Factors included a slow early launch for its cholesterol-lowering PCSK9 therapy, Praluent, combined with worries about a patent case also focused on Praluent. “

“Electronic connector maker Amphenol aided quarterly performance. Early in the period, the company completed its acquisition of FCI Asia, and the ensuing integration, in our view, should provide ample opportunities for realizing synergies and ultimately improving margins. “

Fund disclosures

In summary, I recommend that funds include three additional information that would make fund due diligence more user friendly. The first one is relatively simple and would only require adding index weights to the portfolio holdings. This would clearly indicate the true stock bets of the fund manager. The second addition is a risk measure, the Capture Ratio. This is a relatively new measure, but is extremely useful due to its intrinsic simplicity. Funds have tended to not report on risk since it was difficult for a layman investor to understand risk. Clearly, Capture Ratio makes it easy for everyone to understand risk. The third and final information to be added is a portfolio commentary from the fund manager. Unlike a normal commentary, it is incumbent on the fund manager to give critical details of the fund’s performance attribution at an individual stock level. If the fund disclosures are done properly, the funds would be able to keep investors and attract new investors. 


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