[Federal Register Volume 68, Number 247 (Wednesday, December 24, 2003)]
[Proposed Rules]
[Pages 74820-74828]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-31695]



[[Page 74819]]

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Part VI





Securities and Exchange Commission





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17 CFR Part 270



Request for Comments on Measures To Improve Disclosure of Mutual Fund 
Transaction Costs; Proposed Rule

  Federal Register / Vol. 68, No. 247 / Wednesday, December 24, 2003 / 
Proposed Rules  

[[Page 74820]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release Nos. 33-8349; 34-48952; IC-26313; File No. S7-29-03]
RIN 3235-AI94


Request for Comments on Measures To Improve Disclosure of Mutual 
Fund Transaction Costs

AGENCY: Securities and Exchange Commission.

ACTION: Concept release; request for comments.

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SUMMARY: The Securities and Exchange Commission is seeking public 
comment on a number of issues related to the disclosure of mutual fund 
transaction costs. We seek comment on, among other things, whether 
mutual funds should be required to quantify and disclose to investors 
the amount of transaction costs they incur, include transaction costs 
in their expense ratios and fee tables, or provide additional 
quantitative or narrative disclosure about their transaction costs. We 
also seek comment on whether mutual funds should be required to record 
some or all of their transaction costs as an expense in their financial 
statements. The Commission requests comment from investors, investment 
companies, investment advisers, the financial services industry, 
academics, regulators, and the public generally on the issues 
summarized in this release, the specific questions located in Sections 
III (Alternatives for Quantifying Transaction Costs), IV (Accounting 
Issues), V (Alternatives that Provide Additional Information About the 
Level of Transaction Costs), and VI (Review of Transaction Costs by 
Fund Directors) of the release, and on any other issues that commenters 
believe relevant.

DATES: Comments must be received by February 23, 2004.

ADDRESSES: To help us process and review your comments more 
efficiently, comments should be sent by hard copy or electronic mail, 
but not by both methods.
    Comments sent by hard copy should be submitted in triplicate to 
Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 
Fifth Street, NW., Washington, DC 20549-0609. Comments also may be 
submitted electronically at the following E-mail address: [email protected]. All comment letters should refer to File No. S7-29-
03; this file number should be included in the subject line if 
electronic mail is used. All comments received will be posted on the 
Commission's Internet Web site (http://www.sec.gov) and made available 
for public inspection and copying in the Commission's Public Reference 
Room, 450 Fifth Street, NW., Washington, DC 20549.\1\
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    \1\ We do not edit personal identifying information, such as 
names or electronic mail addresses, from electronic submissions. You 
should submit only information that you wish to make available 
publicly.

FOR FURTHER INFORMATION CONTACT: Paul Goldman, Assistant Director, or 
Jacquelyn Rivas, Staff Accountant, Office of Financial Analysis, 
Division of Investment Management, (202) 942-0510, at the Securities 
and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-
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0506.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
II. Background
    A. Types of Transaction Costs
    1. Commissions
    2. Spread Costs
    3. Market Impact Costs
    4. Opportunity Costs
    5. Magnitude of Transaction Costs
III. Proposals to Quantify Transaction Costs
    A. Quantify Commission Costs Only
    B. Quantify All Transaction Costs
    C. Quantify the Effect of Daily Decisions to Trade
    D. Sell-Side Alternatives
IV. Accounting Issues
V. Alternatives that Provide Additional Information about the Level 
of Transaction Costs
    A. Existing Disclosure Requirements
    1. Portfolio Turnover
    2. Dollar Amount of Commissions Paid
    B. Improving Disclosure Related to the Level of Transaction 
Costs
    1. Disclose Transaction Costs in Terms of Rated Categories
    2. Portfolio Turnover
    3. Information about Average Net Flows
    4. Other Narrative Disclosures
    5. Brokerage Costs and Average Commission Rate per Share
    6. Disclosure of Gross Returns
VI. Review of Transaction Costs by Fund Directors

I. Introduction

    The Securities and Exchange Commission (``Commission'') is 
considering various alternatives designed to improve the information 
that mutual funds disclose about their portfolio transaction costs. 
Mutual funds incur transaction costs when they buy or sell portfolio 
securities. Transaction costs are significant for two reasons. First, 
for many funds, the amount of transaction costs incurred during a 
typical year is substantial. One study estimates that commissions and 
spreads alone cost the average equity fund as much as 75 basis 
points.\2\ Second, fund managers are subject to a number of conflicts. 
Commissions, which are paid out of fund assets, may, for example, be 
used to pay for research or trading support functions (brokerage 
services) that might otherwise be paid for by the fund's investment 
adviser (soft dollar commissions).\3\
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    \2\ John M.R. Chalmers, Roger M. Edelen, Gregory B. Kadlec, Fund 
Returns and Trading Expenses: Evidence on the Value of Active Fund 
Management, Aug. 30, 2001, at 10 (available at http://finance.wharton.upenn.edu/edelen/PDFs/MF_tradexpenses.pdf). These 
estimates omit the effect of market impact and opportunity costs, 
the magnitude of which may exceed commissions and spreads.
    \3\ But see NASD Rule 2839 (K).
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    Fund directors play a pivotal role in monitoring these conflicts. 
As explained in further detail below, transaction costs are not readily 
apparent to investors. These costs, however, must be disclosed to a 
fund's board of directors where such costs bear on the reasonableness 
of the fund's payments to the fund manager or its affiliates. Thus, it 
is imperative that the fund's directors both understand and heavily 
scrutinize the payment of such costs by the fund. The fund's board 
should demand, and the fund's adviser should provide, all information 
needed to undergo this review process. In the absence of vigilant 
oversight by the fund's boards, transaction costs may include payment 
for services that benefit the fund's adviser at the expense of the 
fund.
    Although transaction costs are taken into account in computing a 
fund's total return, they are not included in a fund's expense ratio 
because under generally accepted accounting principles they are either 
included as part of the cost basis of securities purchased or 
subtracted from the net proceeds of securities sold and ultimately are 
reflected as changes in the realized and unrealized gain or loss on 
portfolio securities in the fund's financial statements. As a result, 
current disclosure requirements focus on providing fund investors with 
information about two items that are related to transaction costs--
portfolio turnover rate and dollar amount of brokerage commissions. All 
mutual funds (except money market funds) are required to disclose in 
their prospectuses the annual rate of portfolio turnover that they have 
incurred during the last five fiscal years. Investors can compare 
turnover rates to obtain an indication of how transaction costs are 
likely to vary among different funds. Funds (with the exception of 
money market funds) also must disclose in the Statement of Additional 
Information (``SAI'') the actual dollar amount of

[[Page 74821]]

brokerage commissions that they have paid during their three most 
recent fiscal years.\4\ The Commission is concerned that the current 
disclosure requirements do not directly address a fund's overall 
transaction costs or elicit sufficient information about these costs.
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    \4\ All funds are required to provide their SAI to investors 
upon request. In addition, the SAI of any fund may also be accessed 
via the Commission's Web site (http://www.sec.gov) and frequently on 
a fund's or a fund sponsor's Web site.
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    Some investors and financial industry observers have expressed 
similar concerns. For example, at hearings held on March 12 and 
November 4, 2003 by the U.S. House of Representatives Subcommittee on 
Capital Markets, Insurance and Government Sponsored Enterprises, and on 
November 3, 2003 by the Senate Subcommittee on Financial Management, 
the Budget and International Security, a number of witnesses testified 
that inadequate information about portfolio transaction costs makes it 
difficult for mutual fund shareholders to know the overall cost of 
their investment.\5\
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    \5\ The House of Representatives recently passed legislation 
entitled the ``Mutual Funds Integrity and Fee Transparency Act of 
2003'' (HR 2420) that would, among other things, mandate a new 
document in which mutual funds would disclose their fees to 
investors and directed the Commission to issue a concept release on 
issues related to mutual fund transaction cost disclosure. H.R. 
2420, 108th Cong. (2003). HR 2420 would also require funds to 
disclose their portfolio turnover rate in the new fee disclosure 
document and provide a textual explanation of the impact of high 
portfolio turnover rates on fund expenses and performance. 
Additionally, the Commission has proposed that fund shareholder 
reports be required to include, among other things, the costs in 
dollars associated with an investment of $10,000, based on a fund's 
actual expenses and return for the period. Investment Company Act 
Release No. 25870 (Dec. 18, 2002). The Commission is also today 
proposing to enhance disclosure regarding breakpoint discounts on 
front-end sales loads.
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    The Commission is aware of the need for transparency of mutual fund 
fees and expenses and committed to improving disclosure of the costs 
that are borne by mutual fund investors; but it is mindful of the 
complexities associated with identifying, measuring, and accounting for 
transaction costs. Thus, the Commission is considering how mutual fund 
transaction cost disclosure requirements should be revised to provide 
more meaningful information to fund investors. In particular, the 
Commission is considering whether mutual funds should be required among 
other things to (1) quantify in some meaningful way and disclose some 
or all of their portfolio transaction costs without including these 
costs in their expense ratios and fee tables; (2) quantify some or all 
transaction costs and include them in expense ratios and fee tables; 
(3) provide other quantitative information about the level of 
transaction costs, or (4) some combination of the above. The Commission 
also seeks comment on whether mutual funds should be required to treat 
transaction costs, or a portion thereof, as an expense in their 
financial statements.
    This release invites comment on both the general topic of how to 
improve the disclosure of mutual fund transaction costs and a number of 
specific questions. For ``yes or no'' questions, please explain the 
reasons for your response. For questions with respect to alternatives 
for disclosing some or all transaction costs in fund expense ratios, 
fee tables or in other numerical formats, please be as specific as 
possible about how these alternatives may be accomplished, or why these 
alternatives are not feasible. Discussion is encouraged with respect to 
specific formulas that should be used, and specific recordkeeping and 
operational procedures that should be required in order to implement 
numerical disclosures.
    The remainder of this release examines a number of major issues 
with respect to disclosure of portfolio transaction costs. Section II 
describes the different types of portfolio transaction costs and 
estimates their magnitude. Section III identifies and discusses various 
proposals for additional quantitative disclosures. Section IV discusses 
issues related to how funds account for transaction costs and report 
them in their financial statements. Section V explains the current 
requirements with respect to disclosure and identifies and requests 
comment on possible new disclosures related to the level of transaction 
costs. Section VI discusses the review of transaction costs by fund 
directors.

II. Background

A. Types of Transaction Costs

    Broadly defined, a mutual fund's transaction costs include all of 
its costs that are associated with trading portfolio securities.\6\ 
Transaction costs include commissions, spreads, market impact costs and 
opportunity costs.
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    \6\ See Larry Harris, Trading and Exchanges: Market 
Microstructure for Practitioners (2003) at 420-441 (discussing the 
components of transaction costs, including explicit and implicit 
costs, as well as alternative methods for estimating the magnitude 
of transaction costs).
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1. Commissions
    Commissions generally refer to charges that a broker collects to 
act as agent for a customer in the process of executing and clearing a 
trade. Commissions are the only type of transaction cost that can be 
measured directly. Measurement is easy because the commission is 
separately stated on the transaction confirmation and is paid directly 
from fund assets.\7\ Trades for which commissions are paid generally 
involve equity securities traded on the exchanges. Equity securities 
are also traded on NASDAQ and through dealers. Although historically 
NASDAQ trading has been effected primarily on a spread basis, more and 
more equity trades are being done as single price riskless principal 
trades,\8\ and the cost of these trades is now more frequently charged 
and identified as a commission equivalent.\9\ Consequently, it appears 
that quantification of commission-type fees on equities has become 
easier. In fact, the commission on the average NASDAQ trade (almost 16 
basis points) now approaches the commission on the average NYSE trade 
(18 basis points).\10\
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    \7\ Stephen A Berkowitz and Dennis E. Logue, Transaction Costs: 
Much ado about everything, Journal of Portfolio Management (Winter 
2001) at 68.
    \8\ See Harold Bradley, Senior Vice President, American Century 
Investment Management, Statement Before the House Subcommittee on 
Capital Markets, Insurance and Government Sponsored Enterprises 
(Mar. 12, 2003).
    \9\ The Commission has recognized that money managers opting for 
certain riskless principal transactions would now be informed of the 
entire amount of the market maker's charge for effecting the trade. 
See Exchange Act Release No. 45194 (Dec. 27, 2001).
    \10\ Justin Schack, Trading Places, Institutional Investor (Nov. 
2003) at 32.
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2. Spread Costs
    Spread costs are incurred indirectly when a fund buys a security 
from a dealer at the ``asked'' price (slightly above current value) or 
sells a security to a dealer at the ``bid'' price (slightly below 
current value). The difference between the bid price and the asked 
price is known as the ``spread.'' Spread costs include both an imputed 
commission on the trade and any market impact cost associated with the 
trade as discussed below.\11\
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    \11\ Funds incur spread costs on trades that are made on a 
principal basis (e.g., NASDAQ trades executed from dealer 
inventory). Dealer spreads compensate brokers and broker-dealers for 
maintaining a market's trading infrastructure (i.e., price discovery 
and execution services) and may also reflect the impact of large 
orders on the prices of securities. The proportion of these two 
components varies among different trades. The market impact cost 
component of dealer spreads reflects dealers' inventory management 
costs. These costs have a significant impact on the spread between 
the dealer's bid (buy price) and ask (sell price). Although spread 
costs cannot be directly calculated, they can be estimated with data 
collected some time after the trade is executed. See Berkowitz and 
Logue, supra note at 65-68.

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[[Page 74822]]

3. Market Impact Costs
    Market impact costs are incurred when the price of a security 
changes as a result of the effort to purchase or sell the security.\12\ 
Stated formally, market impacts are the price concessions (amounts 
added to the purchase price or subtracted from the selling price) that 
are required to find the opposite side of the trade and complete the 
transaction.\13\
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    \12\ See Harris, supra note 6 at 421. The average trade on the 
New York Stock Exchange and on NASDAQ is approximately 1,700 shares. 
The average order placed by institutions (including mutual funds) is 
44,600 shares, according to an estimate from Plexus, Inc. See Wayne 
H. Wagner, Chairman, Plexus Group and Senior Vice President, Chase 
JPMorgan Chase Co., Statement Before the House Subcommittee on 
Capital Markets, Insurance and Government Sponsored Enterprises of 
the Committee on Financial Services (Mar. 12, 2003). Basic economics 
dictate that, if the supply of a good or service is held steady, 
increased demand drives up the price. Large trades have an impact on 
price. They ``move the market'' (drive the price up if the fund is 
buying; down if the fund is selling.)
    \13\ See Berkowitz and Logue, supra note 7 at 67.
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    Market impact cost cannot be calculated directly. It can be roughly 
estimated by comparing the actual price at which a trade was executed 
to prices that were present in the market at or near the time of the 
trade.\14\ Impact cost may be reduced by stretching out a trade over a 
long time period. The benefit of reduced impact cost may be reduced or 
eliminated by an increase in opportunity cost.
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    \14\ See Harris supra note 6 at 422-423. Theory suggests 
comparing the actual price paid or received to what would have 
prevailed had the order never been placed. In practice, however, 
only the market prices and bids and offers near the time of the 
trade can be observed.
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4. Opportunity Costs
    Opportunity cost is the cost of missed trades.\15\ The longer it 
takes to complete a trade, the greater the likelihood that someone else 
will decide to buy (or sell) the security and, by doing so, drive up 
(or down) the price.\16\
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    \15\ See Harris, supra note 6 at 421.
    \16\ An opportunity cost is incurred when three conditions hold: 
(1) The price of a stock rises (falls) after an investor decides to 
buy (sell) it, but before he or she is actually able to do so; (2) 
the price change is independent of the investor's decision; and (3) 
the price change is ``permanent''--i.e., it is caused by the 
dissemination of information relevant to the valuation of the asset. 
Other factors may influence the price of an asset, such as temporary 
liquidity imbalances, but they do not generate opportunity costs. 
See Robert A. Schwartz and Benn Steil, Controlling Institutional 
Transactions Costs, The Journal of Portfolio Management (Spring 
2002) at 43.
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    Opportunity cost cannot be measured directly. The joint effect of 
market impact and opportunity cost can be estimated by comparing market 
prices at the time that the transaction was conceived to the price at 
which the transaction was actually executed. Consulting firms have 
developed quantitative tools that attempt to estimate these costs for 
their clients.\17\
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    \17\ See Berkowitz and Logue, supra note 7 at 70.
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5. Magnitude of Transaction Costs
    Although estimates of the magnitude of transaction cost and its 
components vary, the following estimates are representative. For the 
average stock fund, commission costs have been estimated at almost .30% 
of net assets \18\ (an amount equal to approximately 20% of the 1.42% 
expense ratio of the average long-term mutual fund in 2002); and spread 
costs have been estimated at approximately .45% of net assets \19\ 
(approximately 30% of the average expense ratio.)\20\ Market impact 
cost and opportunity cost are more difficult to measure. One study 
estimates that total transactions costs (including market impact and 
opportunity costs) for large capitalization equity transactions range 
from 0.18% to as much as 1% of the principal amount of the 
transaction.\21\ Another study estimates that for institutional 
investors, under relatively stable market conditions, opportunity costs 
may amount to 0.20% of value.\22\
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    \18\ Miles Livingston and Edward O'Neal, Mutual Fund Brokerage 
Commissions, Journal of Financial Research, Vol. XIX, No. 2 (Summer 
1996) at 280. See also, Chalmers, Edelin, and Kadlec, supra note 2 
at 2; Rich Fortin and Stuart Michelson, Mutual Fund Trading Costs, 
Journal of Investing, Vol. 7, No. 1 (Spring 1998) at 67.
    \19\ See Chalmers, Edelen, and Kadlec, supra note 2 at 10.
    \20\ Morningstar Principia Pro Database, Apr. 2003 edition.
    \21\ See Berkowitz and Logue, supra note 7 at 67.
    \22\ See Schwartz and Steil, supra note 16 at 43-44.
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    To summarize, commissions are explicit costs, readily identifiable 
and quantifiable. Spread, impact, and opportunity costs are implicit 
costs. Because the implicit costs, which are difficult to identify and 
quantify, can greatly exceed the explicit costs, there is no generally 
agreed-upon method to calculate securities transaction costs.\23\
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    \23\ ``Transaction cost measurement is as much an art as a 
science. It's very difficult to accurately measure implicit trading 
costs. Not all companies use the same methodology, and there's no 
commonly accepted standards as to how to measure price impact.'' See 
Alison Sahoo, SEC Weighs Trading Cost Rule, Seeks Industry Input, 
Ignites.com (July 22, 2003) (quoting Ananth Madhavan, managing 
director of ITG, a provider of equity-trading services and 
transaction research to institutional investors and brokers).
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III. Proposals To Quantify Transaction Costs

    During recent years, a number of commentators have argued that 
although transaction costs represent a significant portion of the 
overall expenses incurred by a mutual fund, current disclosure 
requirements fail to provide investors with adequate information about 
these costs. Most recently, during hearings held on March 12, 2003 by 
the House Committee on Financial Services, Subcommittee on Capital 
Markets, Insurance and Government Sponsored Enterprises, and on 
November 3, 2003 by the Senate Committee on Governmental Affairs, 
Subcommittee on Financial Management, the Budget, and International 
Security, several witnesses testified about the opacity of portfolio 
trading costs and made suggestions for additional narrative and 
quantitative disclosure. Suggested improvements tend to fall into three 
broad alternatives that would require funds to: (1) Quantify and 
disclose their commission costs; (2) quantify and disclose all of their 
transaction costs; or (3) provide other information related to the 
level of transaction costs. In this section of the release, we describe 
in more detail the alternatives for quantifying transaction costs and 
request comment on the alternatives. Alternatives for providing 
additional information about the level of transaction costs are 
described and comment is requested in Section V of this release.

A. Quantify Commission Costs Only

    The dollar amount of commissions paid is easily determined. As 
previously indicated, the commission appears on the confirmation of 
each transaction and funds already report in their SAIs the aggregate 
dollar amounts of commissions paid.
    Some commentators have proposed that mutual funds be required to 
disclose the commissions they pay to effect securities transactions and 
include the result in their expense ratios and fee tables.\24\ They 
argue that disclosing portfolio commissions would provide additional 
information about the amount of transaction costs that funds incur, 
thus permitting investors to make better informed investment decisions. 
The average commission paid by institutional investors is about 5 to 6 
cents per share, but can range from 1 cent to 12 cents per share.\25\ A 
portion

[[Page 74823]]

of these commissions may be used to obtain soft dollar benefits (i.e., 
research and other services as permitted by section 28(e) of the 
Securities Exchange Act of 1934) that may benefit the manager. The 
limited transparency of soft dollar commissions may provide incentives 
for managers to misuse soft dollar services.
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    \24\ See John Montgomery, President, Bridgeway Funds, and Gary 
Gensler, Former Undersecretary of the Treasury for Domestic Finance 
and Author of The Great Mutual Fund Trap, Statements Before the 
House Subcommittee on Capital Markets, Insurance and Government 
Sponsored Enterprises (Mar. 12, 2003).
    \25\ See Harris, supra note 6 at 151. In 1998, the Commission's 
Office of Compliance Inspections and Examinations (OCIE) conducted 
limited scope on-site inspections of the soft dollar activities of 
75 broker dealers and 280 investment advisers and investment 
companies. OCIE found the average cost of soft dollar executions was 
6 cents per share. See Office of Compliance Inspections and 
Examination, SEC, Inspection Report on the Soft Dollar Practices of 
Broker-Dealers, Investment Advisers and Mutual Funds (Sept. 22, 
1998) (available at http://www.sec.gov/news/studies/softdolr.htm) 
(``Inspection Report'').
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B. Quantify All Transaction Costs

    Some commentators have suggested that mutual funds be required to 
quantify and disclose all of the transaction costs that they incur.\26\ 
This alternative would provide the advantages associated with the 
previous alternative (including commissions in the expense ratio) while 
eliminating any disadvantages associated with quantifying some, but not 
all transaction costs.\27\
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    \26\ See John C. Bogle, Founder and Former Chief Executive, 
Vanguard Group and President, Bogle Financial Markets Research 
Center, Statement Before the House Subcommittee on Capital Markets, 
Insurance and Government Sponsored Enterprises (Mar. 12, 2003); and 
Mercer Bullard, Founder and President, Fund Democracy, Inc., 
Statement Before the Senate Subcommittee on Financial Management, 
the Budget, and International Security (Nov. 3, 2003).
    \27\ ``The ability to figure out trading costs is there. When 
these companies want internal efficiencies to reduce expenses or 
improve sales there's no shortage of money to do that. But as soon 
as someone asks them to spend money on what they are charging 
shareholders, they bellyache. Trading costs are paid out of 
shareholders' money. They should decide what they pay.'' See Sahoo, 
supra note 23 (quoting Max Rottersman of fundexpenses.com, a website 
that monitors mutual fund costs and expenses).
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    This alternative raises the issue of the difficulty of quantifying 
spreads, market impacts, and opportunity costs. Consultants and 
academics derive transaction cost estimates that include spreads and 
market impact costs by using a variety of algorithms to compare the 
actual price that was paid in each transaction with the market price 
that prevailed at some time before \28\ or after \29\ the transaction 
was completed. Perhaps the most all-inclusive way to measure 
transaction cost is another method called ``implementation shortfall.'' 
Implementation shortfall measures the transaction cost of each trade as 
the difference between the price of all trades you intend to make 
(trades actually made plus intended trades that fail to execute) and 
the price that prevailed in the market when each decision to trade was 
made.\30\
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    \28\ A ``before trade'' measure compares the actual price of 
each trade with the price that prevailed in the market before the 
transaction was completed. See Andre F. Perold, The Implementation 
Shortfall: Paper vs. Reality, Journal of Portfolio Management 
(Spring 1988) at 8.
    \29\ In an ``after trade'' measure, the market price might be 
today's closing price, tomorrow's closing price, some other price in 
effect after the fund completed the trade, the average of the high 
and the low for the day, or a weighted average of all prices at 
which market participants transacted on that day. See Perold, supra  
note 28 at 7.
    \30\ The concept of ``implementation shortfall'' was introduced 
by Treynor in 1981. See Jack L. Treynor, What Does it Take to Win 
the Trading Game?, Financial Analysts Journal (Jan.-Feb. 1981). at 
55-60; see also Perold, supra note 28 at 8. Implementation shortfall 
is defined as a measure of the degree to which execution, market 
impact and opportunity costs prevent the investor from taking 
advantage of his or her stock selection skills. See Perold, supra 
note 28 at 5-6. Implementation shortfall can be interpreted as the 
difference in value between an actual portfolio and a corresponding 
paper portfolio. A paper portfolio is an imaginary portfolio that is 
constructed on paper to see what would happen if certain trades were 
actually made. To measure transaction costs, a trader must specify a 
benchmark price at which he buys or sells securities for his paper 
portfolio. The difference in value between the actual portfolio and 
the corresponding paper portfolio measures the trader's cost of 
implementing trading decisions relative to this benchmark. Since 
implementation is generally accomplished at a cost, paper portfolios 
typically earn better returns than the corresponding actual 
portfolios. Harris, supra note 6 at 426. Leinweber illustrates the 
implementation shortfall concept by noting that from 1979 to 1991 
stocks classified as ``Group 1'' by Value Line had an annualized 
return of 26.3% while the Value Line mutual fund that contained the 
same stocks returned only 16.1%. The difference between the paper 
return and the actual portfolio return is the cost of trading. David 
J. Leinweber, Using Information from Trading in Trading and 
Portfolio Management, 4 Journal of Investing, No. 1 (1995) at 40.
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    With respect to the before trade and after trade methods, a common 
standard would need to be chosen from among the wide variety of 
estimation techniques that are used, opportunity costs would remain 
unaccounted for, and some measures in this category may be vulnerable 
to being ``gamed.''\31\
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    \31\ For example, because a before trade measure compares the 
actual price of each trade with the market price in effect before 
the transaction was completed, the market price is known in advance. 
A trader working on behalf of a fund could ``manufacture'' low 
transaction costs if, after each decision to trade is made, the 
trader would wait to take action on the order list, implement only 
the buy orders for which prices have fallen since the receipt of the 
order, implement only the sell orders for which the prices have 
risen, and dismiss the rest of the orders as ``too expensive'' to 
execute. See Perold, supra note 28 at 7-8.
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    The advantages of the implementation shortfall method are that it 
includes all trading costs and is not vulnerable to being gamed. 
However, there is no generally accepted manner to calculate a 
portfolio's implementation shortfall. To monitor performance and comply 
with their best execution responsibilities, many fund advisers already 
gather a substantial amount of data about transaction costs and 
execution quality.\32\ Of course, there may be substantial differences 
in the types of data that fund advisers currently gather that would 
require changes to their systems. However, there may be a fair amount 
of uniformity, at least on the general types of information (e.g., 
trade decision time, time orders are given to brokers, trade execution 
time and price, etc.) that fund advisers maintain.
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    \32\ ``Virtually all the major institutions have a transaction-
cost measuring system in place. They compare their actual execution 
costs to pre-trade benchmarks from models or peer comparisons from 
different firms. That puts pressure on the trading desks to control 
costs. So the guys who aren't doing it are being left behind.'' 
Sahoo, supra note 23 (quoting Ananth Madhavan). ``* * * [M]ore 
pension funds and investment managers are measuring transaction 
costs--either by using proprietary systems or third party services * 
* *. Since the wrenching bear market of 2000-'02, institutions have 
learned that transaction costs can be a significant drag on 
performance, and they have begun managing them as intently as they 
research stocks.'' Schack, supra note 10, at 32.
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C. Quantify the Effect of Daily Decisions to Trade

    Another, more inclusive alternative for measuring transaction costs 
would capture the combined effect of transaction costs and gains and 
losses from short term trading. This ``trade effect'' measure would 
reflect the annual average daily difference between the actual value of 
the portfolio as of the close of each trading day and the hypothetical 
value of the portfolio if no trades had been made that day.
    Trade effect is easy to measure in practice. It is equal to the 
total mark-to-market profits or losses on the security purchases and 
sales made by the fund. For a purchase, the mark-to-market profits or 
losses are computed by multiplying the total quantity traded in the 
security times the difference between the volume-weighted average fill 
price and the price at the end of the period over which the profits or 
losses are measured. For a sale, it is the negative of this 
quantity.\33\
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    \33\ For example, a mutual fund purchases 500 shares of ABC 
Company at a volume-weighted average fill price of $19. The price of 
the security at the end of the measurement period is $20. The mark-
to-market profit or loss associated with this trade would be the 
difference between the fill price and the measurement price (-$1) 
times the number of shares transacted (500), or -$500. 
Alternatively, a mutual fund sells 500 shares of XYZ Company at a 
volume-weighted average fill price of $15. The price of the security 
at the end of the measurement period is $17. The mark-to-market 
profit or loss associated with this trade would be the negative of 
the difference between the fill price and the measurement price 
(+$2) times the number of shares transacted (500), or $1,000. In 
this example, the cost of trading--the trade effect--would be $500 
(-$500 + $1,000), indicating that the trading was not beneficial. If 
assets for the measurement period were $100,000, the trade effect 
would be 0.5%.

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[[Page 74824]]

    For disclosure purposes, each fund could be asked to sum these 
mark-to-market profits and losses across all trades on a given day. 
Funds would divide this sum by total assets for that day and report on 
an annual basis the average of this ratio across all trading days.
    Trade effect includes all realized costs of trading--commission, 
spread and price impacts--plus any short-term trading profits or losses 
incurred as a result of the timing of the trade. Funds produce short-
term trading profits if they can successfully capitalize on short-term 
price changes, for example, when they buy before prices rise. They 
incur short-term trading losses when they poorly time their trades, for 
example, when they buy before prices fall.
    Investors may benefit from disclosure of short-term trading impact 
information because it would allow them to better understand the 
benefits and costs associated with fund portfolio trading. This 
information may particularly help investors interpret fund turnover. 
Although high turnover generally is correlated with poor performance 
due to excessive transaction costs and poor timing, high turnover may 
be desirable for funds that can implement profitable short-term trading 
strategies. Presently, investors lack the information necessary to 
meaningfully discriminate among funds on this basis. Trade effect 
disclosure may allow investors to determine the extent to which fund 
performance--for better or worse--is due to its trading activities.
    If the Commission were to mandate trade effect disclosure, it would 
have to determine the period over which funds would measure their trade 
effect mark-to-market profits and losses. It might seem most natural to 
measure trade effect over the trading day on which each trade occurred 
by comparing trade prices to trade day closing prices. However, this 
comparison could cause some managers to shift their trading towards the 
end of the trading day to minimize their reported trade effect. To 
reduce such incentives, trade effect could be measured by comparing 
trade prices to closing prices on the next trading day.\34\
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    \34\ As noted above, trade effect measures the combined effect 
of transaction costs and short-term trading profits (or losses). The 
use of next day closing prices instead of same day closing prices 
would increase the importance of the short-term trading profits in 
the determination of the trade effect measure. Although variation in 
trade effect due to unpredictable market fluctuations would 
increase, averaging over many securities and over all days in the 
year would largely eliminate the impact of such fluctuations. 
Moreover, since most funds simultaneously buy and sell when 
effecting portfolio adjustments, the effects of unpredictable market 
fluctuations on the mark-to-market profits for buy and sell trades 
often would offset each other.
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D. Sell-Side Alternatives

    Thus far, the discussion in this release has focused primarily on 
the disclosure by mutual funds of their transaction costs and execution 
quality. The Commission also wishes to request comment on whether 
disclosure by markets or broker-dealers of their execution quality for 
large, institutional orders would be helpful to funds in evaluating 
execution costs. For example, broker-dealers handling large orders 
potentially could be required to disclose statistics that compare the 
prices at which their orders are executed with the quotes for a 
security at the time they received the order. To enhance their 
comparability, the statistics could be divided into categories based on 
the size of the order compared to the average daily trading volume in 
the security. Similar disclosure could be required of other venues that 
directly receive and execute institutional orders, such as floor 
brokers, specialists, and electronic trading venues. Such sell-side 
disclosure could represent one part of a comprehensive approach that 
attempted to measure transaction costs throughout the trading cycle. 
Standardized market statistics, which would encompass orders from many 
different institutions, potentially could provide benchmarks for 
execution quality that might assist fund managers and their boards in 
evaluating the execution quality obtained from different broker-
dealers. For example, such statistics might be helpful in evaluating 
the execution quality obtained from affiliated or related broker-
dealers compared to that obtained from those that are independent of 
the fund.\35\
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    \35\ For a fuller discussion of fund director's review of 
transaction costs, see Section VI of this Release, ``Review of 
Transaction Costs by Fund Directors.''
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* * * * *

General Questions About Quantifying Transaction Costs

    1. Is investor decision-making harmed because investors lack 
numerical information about mutual fund transaction costs?
    2. What would be the best way to provide investors with additional 
numerical information about the amount of transaction costs that mutual 
funds incur? Would the information most appropriately be located in the 
prospectus, the SAI, or in another disclosure document?

Questions About Quantifying Commissions and Spreads

    3. Would a requirement to quantify (express as a percentage) and 
disclose brokerage commissions, but not other transaction costs provide 
useful information to fund investors? If funds are required to quantify 
and disclose their brokerage commissions, should the number be included 
in fund expense ratios and fee tables?
    4. Does the increased use of riskless principal trades on NASDAQ 
make it easier to quantify the cost of NASDAQ trades? What proportion 
of NASDAQ trades are subject to commission-equivalent fees?
    5. Would quantifying commissions mislead investors because it would 
result in a number that includes some transaction costs and excludes 
others? Please explain the reasons for your answer.
    6. If the answer to question 5 is yes, would the concern be 
alleviated if funds were required to quantify commissions and provide 
investors with disclosure that details the portion of trades that are 
performed on a commission basis; spread basis; or some other basis 
(e.g., directly from an issuer)?
    7. What effect, if any, would a requirement to quantify commissions 
have on the incentives of fund managers with respect to (1) use of 
principal versus agency transactions; and (2) use of soft dollar 
transactions?
    8. Could any possible adverse effects identified in questions 5 and 
6 be mitigated or eliminated by requiring funds, in addition to 
reporting their commission costs, to estimate the spread cost of their 
principal trades (for example, by imputing to principal trades the 
fund's average commission rate on agency trades)? If yes, should this 
number be included in fund expense ratios and fee tables?
    9. Alternatively, can the portion of spread cost that represents 
payment for executing a trade be measured separately from the portion 
of the spread that represents the market impact cost associated with 
that trade? If yes, should this number be included in fund expense 
ratios and fee tables?

Questions About Quantifying All Transaction Costs

    10. Would a requirement to quantify all transaction costs provide 
useful information to fund investors? Would a requirement to quantify 
all transaction costs, except opportunity costs be a better 
alternative? If you advocate that we mandate either of these 
alternatives, please explain as specifically as possible, how the 
alternative should be

[[Page 74825]]

implemented. Please discuss the specific algorithms, formulas, 
definitions, recordkeeping requirements, and internal control 
requirements that should be used. Commenters are encouraged to address 
the following specific topics:
    A. How should funds measure their spread costs?
    B. How should funds measure their market impact costs?
    C. How should funds measure their opportunity costs?
    D. Should spread, market impact and opportunity costs be measured 
trade-by-trade or for all transactions?
    E. Should spread, market impact and opportunity costs be measured 
absolutely or relative to a benchmark?
    F. Should this number be included in fund expense ratios and fee 
tables?
    11. Would the trade effect measure provide useful information to 
investors, and if so, should we require its disclosure? If the 
Commission mandated trade effect disclosure, should trade effect be 
measured with respect to same day closing prices or next day closing 
prices?
    12. More generally, if the Commission were to choose to require 
disclosure of only one transaction cost measure, which measure should 
it be?
* * * * *

IV. Accounting Issues

    Under generally accepted accounting principals, most portfolio 
transaction costs are either included as part of the cost basis of 
securities purchased or subtracted from the net proceeds of securities 
sold and ultimately are reflected as changes in the realized and 
unrealized gain or loss on portfolio securities in the fund's financial 
statements.\36\ Unfortunately, this accounting treatment provides a 
mutual fund shareholder with an opaque view of portfolio transaction 
costs in a fund's financial statements.\37\ One effect of this lack of 
transparency is that it has impaired the ability of investors to 
evaluate the use of fund assets to obtain research services (as that 
term is defined in section 28(e) of the Securities Exchange Act of 
1934) that are paid for through commissions or spreads.
---------------------------------------------------------------------------

    \36\ For example, if a mutual fund purchases 1 share of XYZ 
Company at a price of $10 with a commission of 5 cents, the mutual 
fund will record the cost of that security as $10.05. However, the 
mutual fund will record the security on its statement of assets and 
liabilities at its market value, for example, $10.03. The fund will 
then record the difference between the cost basis ($10.05) and the 
market value ($10.03) as unrealized gain or loss, in this case, an 
unrealized loss of 2 cents. Therefore, the portfolio transaction 
costs are not reflected directly as expenses of the fund, but are 
reflected in the statement of operations as changes in the realized 
or unrealized gain or loss on portfolio securities. See AICPA Audit 
and Accounting Guide for Investment Companies, paragraph 2.40 (May 
1, 2002).
    \37\ Regardless of whether transaction costs are included in the 
costs basis/settlement proceeds of securities transactions or 
separately identified as operating expenses of the fund, the total 
return of the fund remains the same. Total return is calculated 
based on the net asset value of the fund, which would not be 
impacted by the alternatives in recognizing transaction costs. See 
Item 9 of Form N-1A. Form N-1A is the registration form used by 
open-end investment companies to register under the Investment 
Company Act of 1940 and to offer their shares under the Securities 
Act of 1933 [15 U.S.C. 77a].
---------------------------------------------------------------------------

    The component of commissions that represent execution and clearing 
costs are the equivalent of acquisition or disposition costs incurred 
on physical assets and current accounting principles dictate that they 
be included in the cost basis of securities purchased or in the net 
proceeds from securities sold.\38\ However, the component of 
commissions that represent the costs of services is conceptually an 
operating expense of a fund and should not be included in the cost 
basis of securities purchased or in the net proceeds from securities 
sold.\39\
---------------------------------------------------------------------------

    \38\ See Financial Accounting Standards Board Statement of 
Financial Accounting Concepts No. 2, Qualitative Characteristics of 
Accounting Information.
    \39\ See Financial Accounting Standards Board Statement of 
Financial Accounting Concepts No. 5, Recognition and Measurement in 
Financial Statements of Business Enterprises.
---------------------------------------------------------------------------

    We have attempted to improve the transparency of financial 
reporting when reliable information is available. For example, the 
aggregate value of all fund operating expenses paid for by brokers in 
brokerage offset arrangements are identifiable and measurable, even if 
the brokerage offset credits cannot be allocated to individual trades. 
Accordingly, we adopted a rule under Regulation S-X in 1995 that 
requires a mutual fund to record the value of services received under 
brokerage-offset arrangements as an expense.\40\ The practical result 
is that the portion of commission or spread cost that can be reliably 
identified and measured and that also represents operating expenses of 
the fund is reflected in the expense ratio and in fund expenses.\41\
---------------------------------------------------------------------------

    \40\ See Rule 6-07(2)(g) of Regulation S-X [17 C.F.R. 210.6-
07(2)(g)]. Prior to adoption of this rule, funds would report fund 
expenses, such as expenses for transfer agency, custody, and other 
services net of direct payments made by brokerage firms on behalf of 
funds under brokerage offset arrangements. Rule 6-07(2)(g) requires 
these fund expenses reflect the total amounts paid to fund service 
providers whether directly paid by the fund or by another entity on 
its behalf. The fund is allowed to show after total fund expenses 
the amount of those expenses paid by the brokerage firms. This 
presentation results in a gross-up of income and expenses in the 
statement of operations; however, it provides transparency to 
shareholders on the impact of these arrangements on the fund's 
financial statements. Additionally, this presentation allows the 
expense ratio to properly reflect a component of commission/spread 
costs as an expense.
    \41\ When we adopted this requirement, we also requested comment 
on whether the cost of research services provided by broker-dealers 
should be expensed. Many commentators pointed out the difficulty of 
allocating research received by an adviser among accounts when the 
brokerage of those accounts is used to acquire the research. Some 
commentators, however, supported the additional disclosure of 
research soft dollar practices. See Investment Company Act Release 
No. 21221 (July 21, 1995).
---------------------------------------------------------------------------

    We are considering whether all transaction costs can be and should 
be captured in fund expense ratios and fee tables contained in a fund's 
prospectus. We also are considering whether the cost information 
obtained would be reliable and relevant for financial reporting 
purposes or whether alternatively, some subset of transaction costs 
(e.g., all non-execution and clearing costs) can be reliably measured 
and expensed for financial reporting purposes. We may conclude that the 
standard for including these costs in the fee table is different than 
the standard for including these costs in the fund financial statements 
thereby creating a discrepancy between the two measures. If we conclude 
transaction costs or some subset of transaction costs should be 
included in fund financial statements, those statements would not be 
comparable to other similar entities, such as pension funds, hedge 
funds, and other investment vehicles. We are interested in the 
perspectives of fund investors and fund financial statement preparers 
on the desire for and feasibility of including some or all of this 
information in the prospectus and the fund financial statements.
* * * * *

Questions About Accounting Issues

    13. Would it be appropriate to include some or all transaction 
costs in fund expense ratios and fee tables without accounting for 
these items as an expense in fund financial statements?
    14. Would it be feasible to account for some or all transaction 
costs as an expense in fund financial statements? If it is not feasible 
to reliably measure market impact and opportunity costs, should we 
still require that commission costs be expensed? If yes, should the 
requirement apply to all commission costs or only those commission and 
spread costs that do not relate to the execution and clearing of a 
portfolio transaction (i.e., soft dollars)? If it is not feasible to 
reliably measure all research costs, should we still expense those 
costs that can be reliably measured (i.e., payments to third parties 
for research)?

[[Page 74826]]

    15. Are mutual funds and their managers better able than they were 
in the past to track the portion of commission costs that purchase 
research services from brokers? Has the improvement been sufficient to 
make it feasible for us to require funds to expense these items in 
their financial statements? Since soft dollars are earned based on 
complex-wide trading activity, how should research and other non-
execution costs be allocated among funds? Can soft dollars be traced to 
individual portfolio transactions? (This would entail adjusting the 
basis of the securities purchased in those transactions for the portion 
of the commission cost that was used to purchase research services.) 
Alternatively, should an aggregate adjustment (not specified to a 
particular portfolio transaction) be made to realized and unrealized 
gain or loss? If funds and their managers are not yet capable of 
tracking the portion of commission costs that purchase research 
services from brokers, what factors continue to prevent funds and 
managers from developing this capability?
* * * * *

V. Alternatives That Provide Additional Information About the Level of 
Transaction Costs

A. Existing Disclosure Requirements

1. Portfolio Turnover
    All mutual funds (except money market funds) provide investors with 
information about two items that are related to transaction costs `` 
portfolio turnover rate and dollar amount of brokerage commissions.\42\ 
Funds disclose in their prospectuses the annual rate of portfolio 
turnover that they have incurred during the last five fiscal years.\43\ 
Portfolio turnover rate measures the average length of time that a 
security remains in a fund's portfolio.\44\ The requirement to disclose 
portfolio turnover rate is premised on the observation that a fund's 
transaction costs tend to be highly correlated with its turnover rate, 
other factors held equal.\45\ Thus, by comparing turnover rates, 
investors can obtain an indication of how transaction costs are likely 
to vary among different funds. The advantage that turnover rate (an 
indirect indicator of fund transaction costs) has over the dollar 
amount of brokerage costs (a more direct measure) is that turnover rate 
is less affected by the asset size of a fund. For example, a fund with 
assets of $1 billion is likely to pay many more dollars of brokerage 
commissions than a fund with assets of $100 million, even if their 
turnover rates are identical.
---------------------------------------------------------------------------

    \42\ Money market funds purchase and sell securities on a 
principal basis. Transaction costs for these securities are embedded 
in the purchase price or sale proceeds and are not separately 
stated.
    \43\ See Item 9 of Form N-1A.
    \44\ For example, a fund that has a portfolio turnover rate of 
100% holds its securities for one year, on average. A fund with a 
portfolio turnover rate of 200% holds its securities for six months, 
on average.
    \45\ See, e.g., Livingston and O'Neal, supra note 18 at 283; 
Fortin and Michelson, supra note at 67. But see, Chalmers, Edelen, 
and Kadlec, supra note 2 at 2 (``Turnover is likely to be an 
unreliable proxy for funds trading expenses because it does not 
account for heterogeneity in the per-unit costs of trading an asset. 
For example, an uninformed manager that frequently trades assets 
with a low cost-per-trade may incur lower trading expenses than an 
uninformed manager who infrequently trades assets with high cost-
per-trade.'')
---------------------------------------------------------------------------

2. Dollar Amount of Commissions Paid
    In addition to providing their portfolio turnover rates, funds are 
required to disclose in their prospectus whether they may engage in 
active and frequent trading of portfolio securities to achieve their 
investment strategies. If so, funds must explain the tax consequences 
to shareholders of the increased portfolio turnover, and how the 
trading costs and tax consequences may affect investment 
performance.\46\
---------------------------------------------------------------------------

    \46\ See Instruction 7 to Item 4(b) of Form N-1A.
---------------------------------------------------------------------------

    Funds (with the exception of money market funds) also must disclose 
in their SAIs the dollar amount of brokerage commissions that they have 
paid during their three most recent fiscal years.\47\ Brokerage 
commission amounts, although they must be interpreted carefully, can 
nevertheless provide useful information to fund investors. This 
disclosure informs investors of the magnitude of the fund's overall 
assets that are expended on commissions.
---------------------------------------------------------------------------

    \47\ See Item 16(a) of Form N-1A.
---------------------------------------------------------------------------

B. Improving Disclosure Related to the Level of Transaction Costs

    Another set of alternatives for improving mutual fund transaction 
cost disclosure consists of approaches aimed at improving current 
transaction cost related disclosures or adding new types of disclosure 
that would provide information that is more meaningful and 
understandable to the average investor.
1. Disclose Transaction Costs in Terms of Rated Categories
    One commentator has suggested transaction costs (including 
commissions, spreads, and market impact costs) could be disclosed in 
terms of rated categories, instead of as part of the expense ratio or 
as a stand-alone ratio. The commentator suggested funds would 
categorize their trading costs as either very high, high, average, low 
or very low. The commentator acknowledged this disclosure might be a 
rough estimate, but a ``rough estimate was better than no estimate at 
all.'' \48\
---------------------------------------------------------------------------

    \48\ See Statement of Wayne H. Wagner, supra note 12.
---------------------------------------------------------------------------

    Each fund would be compared to an industry standard. In order for 
such a comparison to be made, a transaction cost measure would have to 
be developed. In addition, we would have to determine whether any 
comparison should be against other funds generally or only against 
similar funds. For example, the transaction costs of an equity fund are 
likely not comparable to transaction costs of a fixed-income or money 
market fund.
2. Portfolio Turnover
    Another possible approach would be to require funds to give greater 
prominence to the portfolio turnover ratio.\49\ Portfolio turnover can 
be calculated easily by all funds. The ratio is simple and easy to 
understand and readily comparable among funds. If portfolio turnover is 
highly correlated with transaction costs, then the portfolio turnover 
ratio may be a good proxy for these costs.\50\ The advantages of being 
able to easily calculate, understand, and compare portfolio turnover 
rates may justify any imprecision in their correlation to transaction 
costs.
---------------------------------------------------------------------------

    \49\ HR 2420 would require funds to disclose their portfolio 
turnover rate in a new document in which mutual funds would disclose 
their fees to investors.
    \50\ See supra note 45.
---------------------------------------------------------------------------

3. Information About Average Net Flows
    Another approach to providing information about transaction costs 
is to provide additional information about the sale and redemption of 
fund shares. The sale and redemption of fund shares often generates 
portfolio transaction costs that all fund investors must bear. Sales of 
fund shares often lead to security purchases as new monies are invested 
in the fund's portfolio. Redemptions often lead to security sales to 
raise money to pay for redemptions. To the extent that sales and 
redemptions do not offset each other, the net difference ultimately 
will generate portfolio transactions. These transactions usually incur 
transaction costs that all investors (in the case of net sales) or all 
remaining investors (in the case of net redemptions) must bear.
    Investors therefore may be interested in the average level of net 
flows into and out of funds. The disclosure of average daily net flow, 
measured as a fraction of total assets, therefore might help investors 
predict the losses that they

[[Page 74827]]

will bear when holding funds that other traders trade. This measure may 
provide investors with information about whether the other shareholders 
in the fund tend to be long-term or short-term investors, and may allow 
them to gauge the portfolio transaction costs generated by short-term 
investors. This measure also would help investors understand the extent 
to which a fund is used by other investors for short-term trading--
i.e., market timing.
4. Other Narrative Disclosures
    Another possible approach is to require a discussion of transaction 
costs and portfolio turnover in the prospectus, the report to 
shareholders, or in another disclosure document. Currently, funds are 
required to discuss the impact of active and frequent portfolio 
trading, which results in a higher portfolio turnover ratio, if it is a 
principal investment strategy. The Commission could require that all 
funds discuss the impact that their management style would have on 
portfolio turnover. Funds also could be required to discuss the impact 
on portfolio transaction costs by: trading in various types of 
securities in which the fund will invest; markets in which they will 
invest (e.g., on an exchange or through over-the-counter transactions, 
or in foreign or domestic markets); and the portfolio management 
strategies that a fund's adviser will employ. In addition, the 
Commission could require a fund to disclose the portfolio turnover rate 
that the fund would not expect to exceed.
5. Brokerage Costs and Average Commission Rate per Share
    The Commission could require that the information on brokerage 
costs that is currently included in the SAI be moved to the fund 
prospectus and prominently displayed with the portfolio turnover 
information to give shareholders a more complete understanding of the 
underlying transaction costs of the fund. Another possibility would be 
to reinstate some form of average commission rate per share 
disclosure,\51\ with appropriate revisions to make it more meaningful 
than the previously eliminated disclosures of such information in the 
fund's financial highlights table.
---------------------------------------------------------------------------

    \51\ In 1995 the Commission amended Form N-1A to require funds 
to disclose in the financial highlights table their average 
commission rate per share. See Investment Company Act Release No. 
21221 (July 21, 1995). This amount was calculated by dividing the 
total dollar amount of commissions paid during the fiscal year by 
the total number of shares purchased and sold during the fiscal year 
for which commissions were charged. In 1998 the Commission 
eliminated this requirement in the belief that the fund prospectus 
is not the most appropriate document through which to make this 
information public. See Investment Company Act Release No. 23064, 
(Mar. 13, 1998). The Commission noted that industry analysts had 
informed the staff that average commission rate information is only 
of marginal benefit to them and to typical fund investors, and that 
the analysts support the view that these rates are technical 
information that typical investors are unable to understand.
---------------------------------------------------------------------------

6. Disclosure of Gross Returns
    Up to this point in the release, we have described the many sources 
of costs incurred by fund investors. We could require an alternative 
disclosure that captures indirectly the total cost of investing in 
funds. Funds could report the return on their investments prior to all 
identifiable costs along with the investment return after such costs 
have been deducted. By reporting both measures side by side, investors 
could get a reasonable idea of how much they are paying for the return 
they receive.
    Current Commission regulations mandate the disclosure of the 
returns that funds generate after fees and expenses (standardized 
returns).\52\ These standardized returns differ from the gross returns 
generated by the fund's portfolio manager.\53\ Gross returns are the 
returns that investment managers produce while standardized returns are 
the returns that are available to shareholders.
---------------------------------------------------------------------------

    \52\ See Item 21(b)(1) of Form N-1A.
    \53\ Gross return refers to the aggregate performance of the 
holdings of a portfolio.
---------------------------------------------------------------------------

    Gross returns are generally higher than standardized returns 
because the standardized returns reflect the loads, fees, expenses, and 
other charges that shareholders pay to obtain and maintain their 
investments. Dilution due to market timing may also cause standardized 
returns to be lower than the associated gross returns.
    If gross returns were disclosed to investors, they could compare 
the returns produced by their managers with the standardized returns. 
Investors would be able to evaluate the efficiency of fund management 
by examining the difference between these two returns. In particular, 
they would be able to determine how much of the portfolio return they 
will actually receive on a net basis.
    The disclosure of gross returns would also allow investors to 
compare the performance of investment managers on an equivalent basis. 
Such comparisons now require that investors take into account 
differences across funds, such as loads, fees, expenses, and dilution. 
Although loads, fees, and expenses are now disclosed, dilution caused 
by portfolio trading is not. Accordingly, investors cannot now compare 
investment managers on a completely equivalent basis.
* * * * *

Questions About Improving Disclosure Related to the Level of 
Transaction Costs

    16. Are there ways to provide a rough estimate of transaction 
costs, or develop a scheme to categorize these costs (for example, 
``very high,'' ``high,'' ``average,'' ``low,'' or ``very low'') under 
general guidelines set by the Commission that would mitigate the 
difficulties involved in coming up with a more precise measure, and yet 
still provide useful information to investors? Could such an approach 
produce results that are consistent enough to permit meaningful 
comparison among funds? If yes, please provide specific suggestions.
    17. In general, do the current disclosure requirements relating to 
transaction costs described in this section of the release provide 
investors with adequate information? If not, what additional 
information should funds provide? Would one or more of the alternatives 
described in this section provide useful information to investors, or 
would the alternatives lengthen the prospectus while providing no real 
benefit? If one or more of these alternatives would provide meaningful 
information, would the information most appropriately be located in the 
prospectus, the SAI, the report to shareholders, or in another 
disclosure document?
    18. Does existing portfolio turnover disclosure provide useful 
information about transaction costs? If additional narrative disclosure 
concerning portfolio turnover and its relationship to transaction cost 
is needed, what information should be required?
    19. Does the existing requirement to disclose the dollar amount of 
commissions paid provide investors with meaningful information about 
transaction costs? How can the existing requirement be improved?
    20. Would an average daily net flow measure provide useful 
information to investors?
    21. Should the Commission consider policies to encourage funds to 
charge purchasers and redeemers of fund shares a fee payable to the 
funds to compensate existing and remaining investors for the costs they 
bear when their funds accommodate the purchases and redemptions of 
other investors? If yes, should the Commission consider requiring funds 
to disclose how they compute these fees, if they require them; and why 
they do not require these fees, if they do not?

[[Page 74828]]

    22. Should the requirement to disclose average commission rate per 
share be reinstated, in either its original form or in a revised form? 
If you advocate that it be reinstated in a revised form, please provide 
specific suggestions.
    23. Is ``transaction costs'' as described in this release a useful 
concept, or would it be more useful for investors to see the effect of 
all costs combined, for example, by showing the following:
    [sbull] Gross or ``pure'' portfolio return;
    [sbull] Net return to shareholders; and
    [sbull] The resulting difference?
    24. If it would be useful for investors to see the effect of all 
costs combined, could funds calculate and report the gross or ``pure'' 
portfolio return, net return to shareholders and the resulting 
difference on an annual basis?
    25. Should the Commission require disclosure of gross returns? If 
so, what definition would be most useful? Of what benefit would these 
returns be to investors? How expensive would it be for funds to compute 
these returns?
    26. Would the disclosure of gross returns allow investors to better 
identify dilution due to market timers?
    27. If portfolio returns are to be disclosed, how should the 
returns be adjusted for fund flows into and out of the portfolio? 
Should they be computed using internal rate of return methods; time-
weighted average methods; or should other methods be used?
    28. If portfolio returns are to be disclosed, should these returns 
only be disclosed, or should the differences between these returns and 
the shareholder returns be disclosed?
    29. Where should these returns or return differences be disclosed, 
and how should they be described?
* * * * *

VI. Review of Transaction Costs by Fund Directors

    Although a mutual fund's investment adviser has an obligation to 
seek the best execution of securities transactions arranged for or on 
behalf of the fund, the adviser is not necessarily obligated to obtain 
the lowest possible commission cost. The adviser's obligation is to 
seek to obtain the most favorable terms for a transaction reasonably 
available under the circumstances.\54\ Given the fact that portfolio 
transactions costs can be substantial and that they involve the use of 
fund assets, portfolio transaction costs must be a significant issue 
for consideration by fund directors. The transaction costs incurred by 
a mutual fund are also generally reviewed by the fund's board of 
directors because section 15(c) of the Investment Company Act requires 
a fund's board to request and review such information as may reasonably 
be necessary to evaluate the terms of the advisory contract between the 
adviser and the fund. Even if the investment adviser obtains best 
execution, research, distribution, and other services purchased by the 
adviser with the fund's brokerage bear on the reasonableness of the 
fund's management fee because the research, distribution and other 
services may otherwise have to be purchased by the adviser itself, 
resulting in higher expenses and lower profitability for the adviser. 
Therefore, for example, mutual fund advisers that have soft dollar 
arrangements provide their funds' boards with information regarding 
their soft dollar practices.\55\
---------------------------------------------------------------------------

    \54\ See Securities Exchange Act Release No. 23170 (Apr. 23, 
1986).
    \55\ See Section 15(c) of the 1940 Act. See also, Inspection 
Report, supra note 25.
---------------------------------------------------------------------------

    In evaluating the use of commissions, fund directors also consider 
the appropriateness of entering directed brokerage arrangements. Under 
a directed brokerage arrangement, the fund asks the investment adviser 
to direct securities transactions to a particular broker that has 
agreed to provide services, pay for services provided by others, or 
make cash rebates to the fund. Funds typically enter into directed 
brokerage arrangements to offset fund expenses, such as audit, legal, 
and custodial fees. Although directed brokerage does not involve the 
conflicts posed by soft dollars, it does raise issues related to how a 
fund's assets are being expended and other issues, including 
disclosure.\56\
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    \56\ All advisers, including the investment advisers of mutual 
funds, have an obligation to act in the best interests of their 
clients and to place client interests before their own. They also 
have an affirmative duty of full and fair disclosure of all material 
facts to their clients. See 15 U.S.C. 80b-6 (2000) (Section 206 of 
the Investment Advisers Act of 1940); S.E.C. v. Capital Gains 
Research Bureau, 375 U.S. 180 (1963). Some of the funds that engage 
in directed brokerage disclose the practice in the prospectus, the 
SAI, and/or the annual report to shareholders. Others use the 
footnotes to the financial statements to make the disclosure. In 
1995, the Commission adopted accounting rules which require funds to 
report all expenses gross of off-sets or reimbursements pursuant to 
a directed brokerage arrangement. See supra note 40. HR 2420 would 
create a specific fiduciary duty for fund boards to review soft 
dollar and directed brokerage arrangements, as well as require an 
annual report to the board on soft dollar and directed brokerage 
payments, as well as summary disclosure in annual reports to 
shareholders regarding the report to the board in these areas.
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* * * * *

Questions About Board Review of Transaction Costs

    30. Are existing requirements for board review of transaction costs 
adequate? If they are not adequate, how can they be improved?
    31. Should boards be required to receive reports with mandated 
information regarding soft dollars and directed brokerage payments? 
Should investors be provided periodically with a summary of these 
reports?
    32. One problem in evaluating execution cost measurements is in 
identifying a standard of comparison. It may be difficult for fund 
directors to assess the fund's execution performance statistics in a 
vacuum, without comparison with other funds' statistics. Should the 
Commission or other independent body collect these statistics from 
similar funds and make available aggregate statistics for comparison 
purposes?
    33. Should fund advisers be required to provide fund boards with an 
internal allocation of their uses of brokerage commissions, indicating 
the amounts and percentage used by the adviser to obtain execution 
services and soft dollar benefits, specifically detailing the types and 
amounts of the various kinds of benefits? Should there be separate 
allocations among types of research, such as research produced by 
underwriters, or other broker-dealer affiliates?
* * * * *
    In conclusion, the Commission believes that shareholders need to 
better understand a fund's trading costs in order to evaluate the costs 
of operating a fund. As outlined above, the Commission intends to 
examine what steps can be taken to improve the disclosure of 
transaction costs in order to make the information more useful and 
understandable to the average investor.

    By the Commission.

    Dated: December 18, 2003.
Margaret H. McFarland,
 Deputy Secretary.
[FR Doc. 03-31695 Filed 12-23-03; 8:45 am]
BILLING CODE 8010-01-P