The Name Game (Part 2): Will the SEC Recast US Fund Names?

“To be, or not to be, that is the question.”

Hamlet, William Shakespeare

In Part 1, we touched on the ongoing debate about what is and what may not be an exchange-traded fund (ETF), but the focus on naming conventions of US funds is much broader than just ETFs. The Securities Exchange Commission (SEC) have just concluded a period of public consultation on its Names Rule. The question remains whether they will act to change how US fund names are constituted or retain the status quo. Like Hamlet, action or inaction is often the most difficult question to answer. 

The SEC had shown some concern regarding the Names Rule for two primary reasons:

  1. The rule has not been reviewed since 2001, and a lot has changed since that time.
  2. In their view, investors put a significant weight on a name when it comes to choosing a fund

The detailed public consultation launched in March and concluded on May 5, 2020. The responses are interesting as the various stakeholders were not shy about letting their views be known. Overall, the industry is very supportive of a standardized ruleset, which is preferable framework to a bilateral disclosure mechanism between funds and the SEC, which ultimately results in fragmentation across the US funds market. 

Here are the top three areas of interest from the consultation:

  1. Over Reliance on Fund Names

One of the reasons cited by the SEC for revisiting the Names Rule in the first place is the notion that even though the existing rules note that retail investors should not merely use a fund’s name as a measure of a fund’s performance, fund names tend to “communicate a great deal to an investor,” making them a critical component of investment decisions. Industry responses suggest that investors are not that superficial, and they do explore many other factors beyond the name of the fund. Appropriate investor disclosure regimes and upcoming regulatory enhancements such as SEC Regulation Best Interest are initiatives to improve investor education and increase the understanding of the important elements that make up a fund.

The SEC’s fundamental concern, however, matches regulatory challenges on a global basis-despite much effort in framing retail investor disclosure documents. Quite often, these documents remain either unread or not fully understood. It appears that the focus to improve investor education along with distributing understandable and accessible disclosure materials will continue for some time to come.

2. ESG: Strategy or Investment Type?

Yes, environmental, social, and governance (ESG) is everywhere in global asset management. The SEC’s interest in ESG was piqued significantly in recent months primarily driven by the growth in ESG, sustainable, or responsible investment funds in the US market. Intriguingly, this market growth is occurring at a time when the SEC has no concrete rules or definitions in place on ESG. The SEC had previously conducted an industry-outreach to gather information on how US funds were defining and screening for ESG. Some felt that this was the first step in the SEC considering an ESG framework for US funds given that is a central point of emphasis in Europe currently. Additionally, ESG is a central theme of the Names Rule consultation.

The primary question at hand is whether ESG is an expression of high-level investment strategy (like value or growth) or is intended to describe a category of portfolio investment (like “high yield bond” or “Japanese Equity”). How the term ESG is ultimately classified by the SEC will dictate whether the term “ESG” is even subject to the Names Rule at all.  So, if the SEC sees the term ESG fund as an indicator of an investment types which ESG funds do or do not invest in such as renewable energy firms, specific exclusion of tobacco companies, then ESG falls into scope.  However, if the SEC views ESG funds as being an indicator of a broader investment approach like investing with the objective of bringing value-enhancing governance, investing based on non-economic objectives such as gender diversity or community engagement without specificity of actual investments, then it will remain out of scope. 

Industry submissions on this issue have been far from unanimous.  Some argue that sustainable investments are a type of investment (in scope), whereas many respondents maintain it is a form of investment strategy (out of scope).

Like Hamlet, the global asset management industry is also pondering an agonizing question currently and that is how exactly do you define “ESG”? Presently, no consensus on definition exists.  There are qualitative and quantitative, financial and non-financial, subjective and objective measures enshrined in the concept of ESG investing, making it a highly nuanced debate. Europe has led the way in attempting to classify and standardize how ESG investments are measured with its Taxonomy Regulation, but no global consensus exists and should the SEC bring ESG under the Names Rule umbrella, this could be another step along the way to adoption of formal ESG regulation for US Funds, a concept that has been raised in SEC circles in recent weeks with the SEC’s Investor Advisory Committee suggesting rulemaking is considered. 

As such, the SEC has a big, complex and nuanced ESG decision ahead of it. 

3. Definition and Thresholds Are Nuanced

As a reminder, a central underpinning of the Names Rule is an asset-based test which requires a fund to invest at least 80 percent of its assets in the manner suggested by its name. The Names Rule doesn’t apply to fund names that describe a fund’s investment objective, strategy, or policies. The SEC asked the industry several questions around calibration of the definitions and thresholds which support the rule. Such as, whether the 80 percent rule should remain valid, use of derivatives, and should the rule apply at point of purchase or in perpetuity?

The industry response contends that the 80 percent threshold should be retained as the standard, tested at the time of investment. On derivatives, the consensus is that the current rule might not truly reflect how certain funds gain synthetic investment exposures. Therefore, the SEC should consider permitting funds to test exposure to an investment type using a “reasonable exposure metric” such as notional exposure where the cost or net present value of a derivative instrument may not be truly indicative of the fund’s exposure.

Bottom Line

What’s in a name indeed. The SEC Names Rule is significant because the name of any product, in any industry can be a key factor in the product’s success or failure. Particularly in the oft cited period of low attention spans, a catchy name can really capture an audience.  So, the scope and level of changes the SEC sees fit may have a material impact not just on the current suite of funds available in the marketplace but could also have an impact upon the future of such name choices. Asset managers must now wait with bated breath to see whether the status quo remains, [or if the time has come for the SEC to “cry havoc and let slip the dogs of war” upon US fund names.]

{or whether they will lament along with the Bard:  “Who steals my purse steals trash…but he that filches from me my good name robs me of that which not enriches him, and makes me poor indeed.”