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ICI Protest May Portend More Disclosure

The Investment Company Institute's call last week for less portfolio holdings disclosure is probably the best indication that the Securities and Exchange Commission is getting ready to increase disclosure requirements, according to industry observers.

"I think the chances are pretty good that there is going to be a call for more disclosure or the ICI would not have reacted so adamantly," said Don Phillips, managing director of Morningstar. "I think the very fact that they're so adamant about this shows how scared they are, which suggests that the SEC is giving this some real thought."

The ICI last week issued an open letter to the SEC callling for lower disclosure thresholds and opposing any initiative that would require funds to increase their portfolio holdings disclosure. The ICI reiterated many of the arguments it has made in the past against increasing the frequency of portfolio holdings disclosure. Those arguments include:

* Requiring more frequent portfolio holdings disclosure will hurt, not help, fund shareholders by encouraging harmful trading practices like front-running by professional traders.

* Such a rule is not necessary because there is no demand from individual shareholders.

* Many funds voluntarily submit portfolio holdings and market competition, not regulation, can adequately provide the disclosure some financial intermediaries want.

* Instead of increasing the frequency of portfolio holdings disclosure, the SEC should simplify shareholder reports, making it easier to get a snapshot view of what funds hold with easy-to-read graphics and charts.

The letter follows a speech made last month by Paul Roye, director of the SEC's division of investment management, who said the SEC is "taking a hard look at disclosure of fund portfolio holdings, with the goal of improving the quality of portfolio schedule information."

Roye suggested that a summary portfolio schedule, in lieu of a full schedule, which highlighted a fund's major holdings, would be more useful to the average mutual fund investor. "If an investor wants the entire schedule, they could request it and it could be forwarded promptly," he said.

The SEC will likely issue a rule proposal in the coming months, according to Mercer Bullard, founder and CEO of Fund Democracy and a former assistant chief counsel at the SEC's division of investment management. Harvey Pitt, the SEC's new chairman, will be confirmed before the end of July, which will allow the SEC to issue a new rule proposal, he said. "Roye has said a couple of times that he wanted to get it out by the end of the summer," Bullard said. "It looks to me like that's pretty likely."

Front Running Smoke Screen

Many of the arguments the ICI makes in its letter against increased portfolio disclosure make little sense and appear to be used in order to obscure more important issues, according to Phillips. "They are making such nonsensical arguments you have to question if there is something else that they are afraid of."

For instance, the ICI's argument that increased portfolio disclosure would allow traders to front-run funds does not add up, Phillips said. "The market moves so quickly these days and fund managers have the ability to reposition the fund so rapidly that creating a paper trail three to four months old in no way would create front running," he said.

The real issue seems to be that the fund industry is increasingly moving into less and less liquid areas of the market, Phillps said. That raises the issue of how funds price illiquid securities.

What one fund establishes for an illiquid security's price may be different from the price another fund establishes for the same security, he said. "I think there is the very real possibility that if you had all funds reporting their portfolios systematically on the same dates, people would figure out different funds owned the same securities and priced them differently. I think that's what the industry is really afraid of here."

The ICI letter also asked the SEC to review existing rules that require funds to disclose their aggregate holdings on a quarterly basis in 13F reports, Phillips said. "It makes no sense to me."

The reports do not help investors make a buy or sell decision on a fund because they report the holdings across an entire fund complex, Phillips said. "It's mind boggling to me that the ICI would ask the SEC to loosen that kind of disclosure," he said. "The only thing that I can say is that the very fact that (13F reports) exist and they haven't drawn any attention to it certainly undermines their notion that quarterly (reports) would be an impossible situation for them. So I guess to be logically consistent they have to attack that as well."