The $3.7 trillion mutual fund industry supports a proposed Securities and Exchange Commission rule that would require a fund to invest at least 80% in the asset class, geographic area or maturity its name suggests.
But industry players and lawyers noted "the devil is in the details"; they say the SEC still has some major hurdles to conquer before the regulation can be implemented.
If the rule goes through as proposed, many mutual fund companies will face two rather onerous choices: change the asset allocation of a mutual fund to meet the 80% test or change the name of a fund.
The rule only applies to mutual funds with names that are descriptive of the fund's investment focus, such as Franklin Small Cap Value Fund or G.T. Global Emerging Markets Fund Inc.
Funds not subject to the law are those with names unrelated to their primary investment focus, such as Fidelity Magellan or Washington Mutual Investors Fund Inc.
The new rule, known as 35D-1, makes several changes to the existing name rule. Currently, funds with descriptive names are required to have 65% of assets invested in the specified asset class, region, sector or maturity range. But that requirement is a "non-fundamental" policy, which means minor asset allocation changes need not be approved by shareholders.
The new rule makes the 80% test a "fundamental policy" requiring shareholder approval, if the fund's manager and trustees want the minimum asset allocation to the main asset class to dip below 80% for any reason.
In a June 9 comment letter to the SEC, Paul Schott Stevens, general counsel for the Investment Company Institute, Washington, said the industry group's support for the proposed 35D-1 rule is conditional upon the SEC's acceptance of three revisions:
The name rule not be a fundamental policy;
The requirement for an 80% minimum investment only apply under "normal circumstances" (not a sudden flood of redemptions, for instance); and
Only funds with an investment policy that allows them to borrow money for investment purposes be required to base the 80% test on net assets plus borrowings. All other funds should base the 80% rule on net assets.
The first two points are important, he said in an interview, because they ensure fund managers will have the flexibility they need to manage their portfolios under many conditions, such as an adverse market, sudden redemptions or sudden cash inflows, that would put the fund temporarily out of compliance with the 80% requirement.
The ICI also raised several questions in its comment letter: Can synthetic securities and derivatives with the same economic characteristics of the stated asset class count toward the 80% test? Will the SEC allow fund managers to use any "reasonable definition" of the terms used in its name in the discussion of the fund's investment strategies and objectives within the prospectus? How will the SEC define what is an acceptable "treasury" or "government" security when a fund uses those terms in its name?
Meanwhile, existing funds are faced with whether to change names to comply or change their investment allocations.
"I think for many fund companies, it makes much more sense to add the descriptives to the fund's name than to change the successful investment strategy [they've] developed over the years. Funds change names all the time - it's not that big a deal to add inserts and to use stickers to rename a fund," said Mark Naber, director of consulting at the Optima Group Inc., Fairfield, Conn., a consulting firm.
Chuck Etherington of American Century Investments, Kansas City, Mo., said the rule "won't cause us to change how we manage or name funds because we are already known as a 'pure play' manager."
"But this rule will make it much more difficult for our competitors to invest in securities outside the stated description of a fund's investment focus in order to squeeze up the performance. This new rule will help with apple-to-apples comparisons and it will be nice to have everyone on the same playing field."
As at American Century, funds with descriptive names at Putnam Investments, Boston, T. Rowe Price Associates Inc., Baltimore, and John Hancock Advisors Inc., Boston, already meet the 80% standard, firm officials said.
Putnam and T. Rowe Price both submitted comment letters to the SEC that were similar in tone to the ICI letter. A spokeswoman for Fidelity Investments, Boston, also noted the company's broad support for the SEC's initiative.
Optima's Mr. Naber said concerns about the rule may be overblown since the bulk of retail mutual fund sales are made through third-party intermediaries, like brokers and financial advisers, who are not relying on a fund's name in selecting funds for clients.
The name change rule received far fewer comments than other SEC rules proposed at the same time: one to simplify the language of prospectuses; the other to permit companies to sell their funds based on a much shorter "profile" prospectus.
The ICI asked the SEC to give the industry more time to comply with the name rule, which is slated to take effect one year from its adoption.
The ICI also supported a "grandfathering" clause, under which the 80% rule will apply only to new investments by a fund.