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Morningstar Calls For More Disclosure

This year's Morningstar conference began with the issuance of a challenge to the fund industry by Morningstar managing director Don Phillips to improve investors' experience with mutual funds.

That challenge could be met, he said, by improving the frequency and timing of funds' portfolio holdings. The downturn in market performance over the past 12 to 18 months has placed greater importance on the issue of portfolio disclosure, Phillips said.

"There are plenty of investors that entered 2000 thinking they had a diversified portfolio when in reality they had a portfolio that was 50, 60, 70% technology," he said. "So it seems to me that that's one major issue the fund industry ought to be looking at saying, What can we do to help investors better understand and better trouble shoot their portfolios?'"

Getting the fund industry to adopt regulations increasing portfolio disclosure is an effort Phillips has regularly supported and he leveled his challenge directly at the Investment Company Institute, which he said is not interested in shareholders best interests. "I think that the industry and particularly its leadership at the ICI have blinders on and they are not addressing the core issues they should be addressing," he said.

Indeed, some have argued that such disclosure encourages short-term trading by tipping investors off to managers' investment decisions. That in turn creates a situation where a manager's move induces front-running, making it difficult to run the fund, they say.

No Water

But that argument does not hold water, Phillips said. "We're talking about a market that moves in nanoseconds," he said. "If you release someone's portfolio 90 days after the [trade], do you think that is going to make any difference whatsoever in the manager's ability to trade the securities?"

Currently, funds are required to disclose portfolio holdings twice a year under the Investment Company Act of 1940.

If investors and advisers knew what securities a funds portfolio held on a more regular basis, it would eliminate redundancies in investor portfolios and minimize the risk that an investor is over-exposed in a certain area, Phillips said.

It could also help avert situations in which a fund has to write down its NAV because of inaccurate valuations, Phillips said.

That situation occurred late last year when the Heartland Group of Milwaukee was forced to write down the NAV of several of its municipal bond funds when it found that thinly traded bonds held by the funds were not priced accurately. In the case of one fund, the NAV dropped nearly 70% because of the writedown.

However, if funds were required to disclose on the same date their portfolio holdings, it would be easy to track the overall liquidity of a fund's portfolio, Phillips said. "We could go in and say what percentage of each funds' assets are unique to that fund, or what percentage are held in more than 50 different funds, or what funds are investing in very illiquid securities and they are the only ones that own them," he said.

By collecting that kind of data, investors could be sufficiently warned of the liquidity of a portfolio and the related risk, he said.

Portfolio disclosure, however, is not an issue the fund industry is willing to examine, he said. The leadership at the ICI is not addressing the core issues," he said.

Phillips made his comments before several hundred executives and fund advisers at the Chicago conference. Phillips offered his view of the state of the mutual fund industry on a panel he shared with Russel Kinnel, Morningstar's director of fund analysis, and Patrick Dorsey, Morningstar's director of stock analysis.

Investors could also benefit from greater disclosure of manager's incentives as well as funds' tax policies, Kinnel said. "I would like to know what a manager's incentives are just as you know what a CEO's incentives are," he said. "Are they paid on after-tax returns, pre-tax returns or asset base?"

Moreover, if funds disclosed how they were managed for taxes, funds could be segmented into groups. Those managed for pre-tax returns and those managed for after-tax returns, Phillips said. That would allow investors in tax-free accounts like IRA's or 401(k)'s to select those funds managed for pre-tax returns while tax-sensitive investors could select funds managed for after-tax returns, Phillips said.

Whatever changes should be made in order to make the fund industry more transparent, market change will always be a constant, according to Dorsey. "The reality is, growth might take a while to come back, but it will come back," he said.