November 20, 2014
Dear Chair White, the Commissioners Several of the SEC, and the Commission,
Thank you for your consideration of my comments and for the opportunity to voice an opinion on this important issue. I provide these comments and suggestions with regard to the discussion of Investment Company Advertising, File No. S7-12-10.
The planned scheme is worrisome and of dubious value to investors, who already have essentially all the data needed to make these decisions. In fact, investors have at their disposal, at little or no cost, all the information needed to create this glide-path set of calculations themselves (and the so-called Baby Boomers have created these calculations for decades during evenings and weekends invested in building retirement spreadsheets).
An illustration – a “nutrition facts table” of target date funds, if you will – is unnecessary, confusing, and risks replacing, in the minds of some investors, the underlying data with the result of one particular analysis. No matter what scheme is selected, that scheme will lend the SEC’s valuable endorsement to a metric of limited value and consume some further quantum of the agency’s limited resources with time-consuming, low-value auditing and policing.
I largely concur with the Comment Letter offered by the Investment Company Institute on 23 August 2010 but would go one step further. In the four years since that letter, we have seen enormous growth, a recovering – even booming – economy, and market conditions that make me and other economists question, with respect, the basic assumptions behind pieces of the Commission’s target date funds discussion.
For instance, for years one assumption has been that in nearly any given sample of market conditions, investment-grade debt will provide less volatility than equity; yet, in this low-inflation, low-interest-rate environment, the years since the Investment Company Institute’s letter have passed with debt offering nearly all the risk and only a sliver of the (remarkable) performance of equities. In a market where much low-quality debt has not been wrung out of the market, where ratings agencies offer plurality opinions, and where the topic of municipal bankruptcies is in the newspaper nearly every week, I would hesitate to advise my own parents – who are approaching retirement – to favour debt over equity as a way to control late-in-path portfolio variance; I would have even more difficulty creating blanket recommendations for millions of investors based on what is little more than “conventional wisdom” about how a target date fund might structure its steer-toward-date allocations.
No matter how much color-coding, food-grouping, warning-labeling, and nutrition-pyramiding the government does in this area, it will only offer a simplification of how a given product relates to a given set of hypothetical market conditions. If this is all the government can offer, then it is better to offer nothing at all and to allow each investor to apply his or her own metrics, envision his or her own future market conditions, and build his or her own models for how a given portfolio might perform in the imagined conditions.
As to the Commission’s question as to how risk measures are used, the majority of people building these kinds of models are looking to maximize early-trajectory growth and minimize late-trajectory variance (the so-called “moon shot” approach); this is done by increasing anticipated variance early in the life of the target fund, typically with a higher loading on equities, and then “retreating” to investment-grade debt as the target date nears. This has been disrupted by the recent unusual market conditions and the difficulty in finding appropriate debt instruments with anticipated yields in the ranges that have been characteristic of investment-grade debt historically. Also, underperformance by some managers has driven an interest in “make up” investments to get funds back on track, often demanding higher-risk assets acquired later in the cycle than might be ideal or typical or contemplated at the fund’s genesis. These two factors, taken together, have driven new interest in holding equities in target funds far later in the cycle than was the case even 12 or 18 months ago. Risk measures, in the contemporary context, are typically used to vet additions to the portfolio (x-versus-x-plus-one modeling) and to run basic simulations to generate the types of metrics typical in the broader mutual funds industry based on VaR and ETL models. Generally, the methological difference is that a target date fund will run convergence-of-y-values models or cluster models in addition, estimating how much a cluster of outcomes might change total portfolio value at a given value T. Most simulations used use data of relatively low (coarse) sampling frequency and are not particularly interesting or sophisticated from a statistical or econometric standpoint.
Overall, I suggest little value is offered to investors by offering an alternative glide path illustration. I submit there is even less value offered to investor-taxpayers by mandating and standardising such a calculation. I finally suggest investors have sufficient data, knowledge, and methodological tools to deduce, independently, the very things the SEC is attempting to calculate on their behalf.
I suggest this because an investor with even a rudimentary understanding of finance and a high-school-level comprehension of mathematics and descriptive statistics can build, for instance, the simple volatility and semi-variance calculations with an ordinary spreadsheet tool in half an hour. Investors can also build simple (or sophisticated) models of correlation and perform discrete or holistic sensitivity analysis, including calculating beta relative to a favourite market metric (or sector metric), without assistance from the government. Again, this requires only the most basic levels of mathematical ability and computer literacy – the type of skills I routinely observe an undergraduate in my class possessing on the first day of his or her first year.
In sum, I suggest investors are well-educated, able, and not necessarily better-equipped in the hypothetical wake of the contemplated expanded regulation. With this in mind, I offer the following, further suggestions.
I suggest the questions peculiar to target date funds are not so unique they demand a wholly different or substantially augmented reporting regime. I suggest that exposure to loss or volatility measurements are objective in their execution but subjective in their selection and design, making them poorly-suited to this type of mandated reporting. I suggest the Commission’s comparison of volatility to beta sets up a false dichotomy and suggests near-target-trajectory-variation is fundamentally vacuum-chambered and wholly decoupled from, and never shifted in course by, market prevailing winds. I suggest the difference between real and nominal returns, particularly for distant-horizon funds, relies upon inflation estimates that are particularly difficult to generate with any degree of credibility (or without more than a sprinkling of speculation) in the current, unusual, near-zero-interest-rate environment. I suggest the Commission should not adopt uniform risk measures or force target date funds to use a particular risk measure. I suggest the Commission should not include two glide-path illustrations, which would both have the potential to confuse investors and to distort the allocations of fund managers. I suggest that no glide path illustration is needed at all but that, should the Commission insist upon including a glide path illustration, that this illustration should be tailored to illustrate performance at the explicit exclusion of risk. I suggest past performance is a metric of limited utility that need not be displayed to investors. I suggest the inclusion of historical risk levels in the case of a fund that has changed its glide path would be misleading and to force their inclusion could create an investor perception of current-period underperformance where no such underperformance exists in fact. I suggest the pool of funds subject to regulation is sufficiently heterogeneous that a blanket rule for the time window (maximum interval) during which risk is discussed or contemplated is inappropriate and unnecessary. I suggest it is not important to require media advertisements in formats like radio, television, and Internet to include the glide path illustration or a textual equivalent. I suggest robust research now exists on the investment psychology of losses and that the bulk of this research seems to indicate that discussing the prospect of investment gains is insufficient to fully or completely counteract the discussion of the prospect of investment losses. As to this final assertion, see, e.g., D. Kahneman et al., “Anomalies…” J. Econ. Perspectives, 5(1), pp. 193-206 (1991); accord R. Thaler, “Mental Accounting Matters” J. Behav. Decis. Making 12, pp. 183-206 (1999).
Thank you, Chair White, for inviting these suggestions and suggestions made already by other learned colleagues.
Regards,
Karl T. Muth
Lecturer in Economics, Public Policy, and Statistics – Northwestern University
SEI Research Fellow – The University of Chicago
Postgraduate Research – The London School of Economics and Political Science
Note: Opinions and comments and any errors in this letter are my own and may not represent the views or positions of institutions with which I am affiliated.