By Mark S. Nelson, J.D.
The SEC’s Office of the Investor Advocate issued a research study on fund performance benchmark usage by funds and investors that also serves as a public comment by the Investor Advocate on a 2020 proposal by the Commission to modernize the disclosure framework for open-end management investment companies by, for example, making investor disclosures more visually engaging and amending prospectus requirements regarding disclosures about fees, expenses, and principal risks (See, Tailored Shareholder Reports, Treatment of Annual Prospectus Updates for Existing Investors, and Improved Fee and Risk Disclosure for Mutual Funds and Exchange-Traded Funds; Fee Information in Investment Company Advertisements, Release No. 33-10814, August 5, 2020). The study concluded that while investors do use fund benchmarks in deciding whether to invest, benchmarks can be presented to bolster funds’ performance and benchmarks remain poorly understood by many investors.
Benchmarks. The study explained that funds’ presentation of performance must include a broad index, although funds may also include a narrow index to supplement that data (the study referred to these indices as primary (broad) and secondary (narrow) based on their correlation with the S&P 500 Index). However, funds must further state in their disclosures that past performance is not an indicator of future performance. According to the study, most funds reviewed (excepting newly created funds with little financial history) used a broad performance benchmark. By contrast, only about 30 percent of funds examined used a narrow index (i.e., 70 percent did not use a narrow benchmark).
Among broad benchmarks, the study said the S&P 500 Total Return Index was the most prevalent. With respect to narrow benchmarks, the study indicated that a group of Russell indices focused on the largest 1,000 and smallest 2,000 U.S. companies that can be further divided into value- and growth-oriented indexes were most prevalent. In general, according to FTSE Russell, the Russell 1000 Index tracks the largest 1,000 U.S. companies by market capitalization and, thus, emphasizes large-cap stocks. FTSE Russell’s Russell 2000 Index tracks the smallest 2,000 U.S. companies by market capitalization and, thus, is a small-cap stock index. Both the Russell 1000 Index and the Russell 2000 Index are subsets of the Russell 3000 Index, which tracks the largest 3,000 U.S. stocks and represents approximately 96 percent of the U.S. equities market.
Methods. The Investor Advocate, with an assist from NORC at the University of Chicago, RAND Corporation, and Ipsos, devised a large behavioral experiment to test how funds and investors use fund benchmarks. The study also included a small set of investor interviews and a larger market data analysis.
Reasons to use, not use benchmarks. The study noted that investors generally tend to use fund benchmarks in making decisions to invest, but that there are varied reasons why some investors chose to rely on benchmarks and other do not. With respect to investors who use benchmarks, the study suggested that three reasons may explain such behavior: (1) investors would otherwise find it difficult to evaluate or compare the thousands of funds available; (2) benchmarks may reveal information about market shocks; and (3) investors are looking for ways to compare unfamiliar or hard to evaluate products.
On the other side of the ledger, the study hypothesized that some investors may ignore benchmarks for several reasons: (1) funds’ disclosures about historical performance may render benchmarks useless; (2) funds may strategically select benchmarks; (3) general lack of understanding about what a benchmark means; and (4) the potential that benchmarks may distort otherwise comparable information because they are poorly matched to a particular fund.
Findings. The study offers a detailed window into fund and investor behaviors regarding benchmarks. Overall, the study noted that funds use a variety of benchmarks, including some funds that use both equity and bond index benchmarks. Qualitative research that was based on a small sample size and, thus, not conclusive, suggested that investors may be sensitive to the visual presentation of fund benchmarks and that investors vary in how they contextualize benchmark data.
Among the findings from the study’s experimental results, the Investor Advocate noted that sophisticated study participants appeared to react more strongly to benchmarks than less sophisticated participants. The study also found that participants reacted similarly to both broad and narrow indices such that there was no evidence suggesting that narrow indices were better received. Moreover, market data analysis indicated that secondary (narrow) benchmarks were not a better basis for comparison than primary (broad) benchmarks. The study noted that benchmarks were classified as either primary or secondary based on whether they had a lower correlation to the S&P 500 Index.
What’s next. The Investor Advocate’s study/public comment on the 2020 fund disclosure proposal adds to the 94 comments already submitted, most of them by the formal end of the comment period on January 4, 2021. The SEC’s Spring 2022 Unified Agenda of Regulatory and Deregulatory Actions continues to include the 2020 proposal and indicates that it is now at the final rule stage with an estimated time frame for adoption by the Commission of October 2022.