Fund Annual Reports Made Simple: 11 Key Changes in the SEC's Proposed Filing and Disclosure Modernization

Posted by John Braun on Nov 23, 2020 12:37:09 PM

Update: Don't miss our Webcast on this topic, in partnership with Morgan Lewis and SEI, on December 15!

On August 5, 2020, the Securities and Exchange Commission issued a rule proposal to modernize the disclosure framework specific to mutual funds and exchange-traded funds (collectively referred to herein as “funds”). The general premise of the proposed rule is that different presentations are useful to different audiences relating to a fund’s reporting of operations and offerings.SEC Disclosure and Filing Update More specifically, while the traditional methods of providing full financial statements and a prospectus to shareholders may be useful to investment professionals and institutional investors, the average investor finds this information clumsy and confusing and would rather have more limited and graphical information focused on items such as the performance and expenses of the fund. In fact, it would not surprise most in the industry to find out that most retail investors are not engaging in a detailed review of the financial statements or offering documents.

This proposed rule intends to be responsive to the simplified demands of retail investors while at the same time ensuring that more detailed and audited information remains available to those interested investors.

The proposed rule is more than 600 pages. Below, we offer a summary of what this proposed rule means specifically related to financial reporting for funds.

Currently, funds are required to file a Form N-CSR semi-annually with the SEC and to provide copies of shareholder reports (including financial statements) to shareholders. The fiscal year filing contains audited financial statements along with an audit report from an independent registered public accounting firm. The requirement under Form N-CSR relative to the audited financial statements remains largely unchanged with the exception of removing the requirement to disclose fund directors and officers, as this information is already disclosed annually, as required, in a fund’s filing of its Statement of Additional Information.

And while the proposed rule still requires funds to file Form N-CSR semi-annually, it also establishes new requirements for an annual and semi-annual report which are to be sent to shareholders. We have summarized each of the presentation items along with changes below. Keep in mind that each of the items below is required to be presented separately for each fund. No fund family presentations are permitted.

Change 1: Expense Example – The report will show a simplified presentation of the current expense example disclosure which will be based on a $10,000 investment and the actual returns and expenses of the fund as follows:

11 Key Changes Chart-1

**Assumes 5% return and 1% expense ratio

Change 2: Management’s Discussion of Fund Performance – The requirements are largely consistent with those currently in place, but there are certain changes and guidance aimed at brevity (i.e. – use of tables, bullet lists, charts, etc.) and are meant to consider the fact that shareholders may not be reading the prospectus in conjunction with the reports, as they may not be receiving it after the initial purchase.

  • $10,000 line graph will remain with 3 changes:
    1. Class being presented is to be disclosed for multi-class funds
    2. Presentation is limited to 10 years regardless of fund’s inception
    3. To define “appropriate broad-based securities market index” as one that represents the overall applicable domestic or international equity or debt markets, as appropriate
  • Performance table will remain with 3 changes:
    1. Requires average annual return of appropriate broad-based securities market index (as defined above)
    2. Requires fund returns without sales charges
    3. Requires returns for each class covered by report for 1, 5 and 10 years
  • Narrative regarding distributions to focus on circumstances when a fund is unable to meet the specified level of distribution in its stable distribution policy or had distributions that resulted in returns of capital

Change 3: Fund Statistics – The full financial highlights are not to be included, but certain specific items such as net assets and portfolio turnover rate will be presented. In addition, the number of portfolio holdings is required to be disclosed, and a fund may reference the full financial highlights from the Form N-CSR under certain circumstances related to the availability of the full financial statements and prospectus.

Funds are also permitted to incorporate additional “statistics” tailored to a fund’s investment strategy that might enable shareholders to better understand the fund’s activities and operations (these can be statistics not required or permitted by Form N-1A) such as tracking error, average maturity of holdings, average credit rating, etc.

Change 4: Graphical representation of holdings – The proposed rule contains certain revisions to the current requirements, including:

  • Currently, funds may base the graphical presentation of holdings on either net assets or total investments. The proposal would also give a fund the ability to present based on net exposure or total exposure to certain investment categories. In certain circumstances, such as those funds with significant investment in derivatives, this would give the reader a better understanding of exposure.
  • Long/short funds may present portfolios separately or in combination.
  • Guidance for funds showing portfolios by credit rating instructing funds to keep descriptions of the organization of the presentation brief, as the SEC has noted current filings often contain unnecessarily lengthy and confusing disclosure.

Change 5: Material fund changes – This section is new to the report and is meant to capture changes that have occurred during the year or will be changing going forward that previously would have been disclosed in the annual prospectus. There is a list of specific changes that must be disclosed if relevant, along with a catch-all, as follows:

  • Change in the fund’s name
  • Change in the fund’s investment objectives or goals
  • An increase in the fund’s ongoing annual fees, transaction fees, or maximum account fee
  • Change in the fund’s principal investment strategies
  • Change in the principal risks of investing in the fund
  • Change in the fund’s investment adviser(s), including sub-adviser(s)
  • Change in the fund’s portfolio manager(s)
  • Any other material fund change that it would like to disclose to its shareholders

Change 6: Changes in and disagreements with accountants – The current disclosure requirements would remain in the financial statements included in Form N-CSR, but the annual report would only include summary level information, such as whether the former accountant resigned, declined to stand for re-election, or was dismissed and the date thereof, as well as a brief, plain English description of disagreement(s) with the former accountant. No disclosure is required to the extent that there were no changes in or disagreements with the accountants.

The concept here is to alert the reader to the disagreement while still maintaining brevity. In addition, the proposed rule specifically notes that the more detailed information relevant to a change in or disagreement with the accountant is more appropriately presented in the audited financial statements.

Change 7: Statement regarding liquidity risk management program – The proposed rule contains guidance to ensure that the disclosure is tailored, concise and informative while noting that disclosure to date has been mostly a regurgitation of the liquidity risk rule and hasn’t provided much useful information for the investor. Specifically, disclosure should include the following:

  • Key factors or market events that materially affected the fund’s liquidity risk during the reporting period
  • Key features of the fund’s liquidity risk management program
  • Effectiveness of the fund’s liquidity risk management program over the past year

Change 8: Availability of additional information – Funds must disclose the availability of additional information on the Fund’s website such as prospectus, financial information, holdings, proxy voting information, and the audited shareholder report.

Change 9: Householding disclosure (optional) – The SEC allows for one copy of certain materials including proxy materials, prospectus and annual reports to be sent to shareholders at the same address, which is referred to as householding. Funds will continue to be permitted to include language in the annual report explaining how to revoke the householding of the annual report.

Change 10: Form and Content – There are general instructions that are meant to be user-friendly that are focused on consistency (presenting items in the order specified in the Form N-1A) and being concise and direct in the narrative that is presented.

Change 11: Electronic Annual Reports – Shareholders will receive the annual and semi-annual report in paper, unless they elect to receive them electronically. The proposed rule recognizes that electronic annual reports will likely be presented in differing formats and technologies to engage the reader but in order to maintain consistency must incorporate the following:

  • Annual report “cover page” requirement applies as the beginning of the report, as there might not be a physical page at the beginning of an electronic report. There are certain required items to be listed on the cover page of the annual report:
    • Fund/class name
    • Ticker Symbol
    • Principal U.S. market(s) for ETFs
    • Statement identifying document as “Annual Shareholder Report”
    • Legend
  • Ordering requirements still apply as described in the Form and Content section
  • Links should be provided when referencing information found elsewhere

Bottom Line: The logic of this rule proposal is sound, and the information required to produce these report changes should all be easily accessible via the books and records already being maintained. If the average shareholder is receiving their financial statements and not engaging in any type of review, either because of the medium in which they are being sent or because of the lack of focus on the information they most care about, sending the financial statements in the traditional form feels illogical and much like the industry is just going through the motions. If, however, a report can be sent to shareholders that focuses on the most important details of a fund’s operations and is digestible, that feels like a value-add to the shareholders and the industry. And for those investors who desire the more detailed information on funds in which they are invested, that information is still easily accessible on the fund’s or SEC’s website.

The SEC's comment period for this proposed rule extends through January 4, 2021.

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