Understanding SEC’s Proposed Changes To ‘Names Rule’
On May 25, 2022, the U.S. Securities and Exchange Commission proposed changes to specific rules that apply to funds regulated under the Investment Company Act of 1940.
These changes focus on the naming and disclosure requirements of a fund in relation to its intended investment objective. The SEC will accept public comments for 60 days after the proposed rule is published in the Federal Register, though the deadline could be extended.
Some of the important proposed changes to the names rule are summarized below, as interpreted by CFRA analysts, though this is not intended to be a comprehensive listing of all the proposed changes or language in the SEC announcement.
This summary also does not address a separate rules proposal from the SEC issued on the same day and related ESG disclosure practices of investment advisors and investment companies, nor does it address the proposed rule issued earlier this year that would require, enhance and standardize emissions and climate-related risk disclosures by public companies.
Expansion of 80% investment rule to any fund whose name implies a specific investment characteristic: In 2001, the SEC adopted Rule 35d-1 (the “names rule”) that governed the naming of registered investment companies. It prohibited a fund from adopting as part of its name any words that the Commission finds are materially deceptive or misleading. In practice, this meant a fund had to invest at least 80% of its assets by value in the type of investment focus—such as industry, country, geographic region—suggested by its name. However, the rule was not universally applied to all funds. For example, the Commission has previously taken the position that fund names that incorporate terms such as “growth” and “value” connote an investment objective, strategy or policy (i.e., “investment strategies”) and are therefore not within the scope of the 80% investment policy requirement. This resulted in some fund names being excluded from the 80% investment requirement. The proposed amendment would require all funds whose names include specific characteristics, including ESG and similar terminology, to be subject to the 80% investment requirement. Where a fund’s name suggests an investment focus that has multiple elements, the fund’s 80% investment policy must address all the elements in the name. However, the SEC has also clarified that fund names with only terms such as “balanced” that reference characteristics of a fund’s portfolio as a whole or “long/short” that reference an investment technique but do not connote an investment focus will not be required to adhere to the 80% investment rule.
Use of text analytics for assigning industry: In its proposal, the SEC notes that it is not reasonable for funds to use only “text analytics” to assign issuers to a given industry, i.e., solely because the issuer’s disclosure documents frequently include words associated with the industry. For example, a fund cannot assume a company is in the “blockchain” business solely based on the number of times “blockchain” is mentioned in its annual report and other disclosure documents. This is likely to have implications for any ETF or mutual fund where ETF or fund holdings are assigned to an industry or theme solely based on the mention of specific terms. For example, the SPDR S&P Kensho New Economies Composite ETF (KOMP) “identifies companies in its New Economy Subsectors using its propriety Natural Language Processing ‘NLP’, which leverages their artificial intelligence capabilities to screen regulatory forms for key words and phrases in the appropriate context relevant to the respective new economy sector to find companies for inclusion.” Funds that rely solely or primarily on text analytics to assign companies to industries will need to review their methodologies or terminology considering this rule change.
Use of ESG terminology in name: At present, some funds (defined by the SEC as “integration funds”) use both ESG and non-ESG factors in their investment decisions and have ESG-related terminology in their names. The SEC has proposed that it would consider an integration fund’s name to be materially misleading if it contains ESG terminology, but ESG factors are not significantly determinative in deciding to include or exclude any particular investment in the fund’s portfolio. Existing integration funds where ESG terminology is used in the name will need to ensure that ESG factors are significant determinants in the investment selection or remove such terminology to comply with the rule change. Requiring a fund’s investment activity to support the ESG investment focus that its name indicates will prevent potential “greenwashing” and reduce the chances that investors will be misled by a fund’s name.
Criteria for departures from 80% rule: Under the names rule, the 80% investment requirement was applicable at the point of investment and “under normal circumstances”. Over time, however, there would often be “style drift,” where the actual investment objective strayed from the original investment. The proposed amendment would specify the circumstances under which a fund may depart from its 80% investment policy, including specific time frames for getting back into compliance. For example, temporary departures would be permitted as a result of market fluctuations not caused by the fund’s purchase or sale of a security or to address unusually large cash inflows or unusually large redemptions.
Treatment of derivatives exposure in 80% rule: The SEC is proposing to amend the names rule to require funds to use a derivatives instrument’s notional amount, rather than its market value, for the purpose of determining the fund’s compliance with its 80% investment policy. Also, they are proposing to amend the names rule to address the derivatives instruments that a fund may include in its 80% basket.
Enhanced disclosure: The SEC is also proposing amendments to funds’ prospectus disclosure requirements that would require a fund to define the terms used in its name, including the criteria the fund uses to select the investments that the term describes. Additionally, under the proposal, funds that provide electronic notices to shareholders will be required to describe not only a change in the fund’s 80% investment policy, but also a change to the fund’s name that accompanies the investment policy change.
Modified reporting and recordkeeping requirements: The Form N-Port that funds file with the SEC will include a new reporting item regarding a fund’s names rule compliance. They also would include a new reporting item requiring a fund subject to the 80% investment policy requirement to indicate, with respect to each portfolio investment, whether the investment is included in the fund’s 80% basket. The proposed amendments would require funds that must adopt an 80% investment policy to adhere to recordkeeping requirements that are designed to provide the Commission and staff, as well as the fund’s compliance personnel, the ability to evaluate the fund’s compliance with the rule’s requirements.
Rationale For The Changes
The document published by the SEC outlines in detail the rationale underlying the proposed names rule changes. The name and disclosure requirements are driven by the SEC’s intent to protect investors from getting misled by a fund’s name or lack of adequate disclosure. Table 1 is CFRA’s summary interpretation of the rationale behind the SEC’s proposed rule change.
Table 1: CFRA’s Summary of Rationale for Proposed SEC Changes to 1940 Act Names Rule
Proposed Names Rule Change | Context and Rationale for Proposed Change |
Expansion of 80% investment rule to any fund whose name implies a specific investment characteristic | Investors often rely inordinately on a fund’s name while evaluating its investment objective and risks. The SEC wants to ensure that fund names, while still being concise, continue to accurately reflect the investment objective and approach of the fund. This is particularly important since asset managers are under commercial pressure to assign fund names that can attract assets in a competitive market. To attract assets, many fund managers include themes such as ESG, cybersecurity or blockchain in their fund names. Applying the 80% investment rule to such funds will ensure that their names are consistent with their investment objectives and exposure. |
Clarification on use of text analytics for assigning issuers to industry | The SEC wants to prevent funds from assigning issuers to specific industries based solely on the use of specific keywords in the issuers' annual reports or other disclosure documents. For example, if an energy company uses the term “blockchain” frequently in its disclosures, this does not automatically imply that it is primarily in the blockchain "industry." The SEC’s intent is to prevent misclassification or misrepresentation of issuers to industries based solely on text analytics. |
Clarification on use of ESG terminology in name | Some existing integration funds (that use both ESG and non-ESG investment criteria) may have ESG terminology in their names although the ESG factors may not always be significant in determining portfolio holdings. The SEC would consider these fund names to be materially deceptive. Its intent is to prevent "greenwashing" by ensuring that ESG terminology is only included in a fund name if the fund uses ESG criteria as a significant determinant factor in its portfolio decisions. |
Clarification of criteria for departures from 80% rule | As originally drafted, the 80% investment rule only applies at the time of investment and “under normal circumstances.” Over time, there is "style drift," where the actual investment objective strays from the original investment. The SEC’s proposed intent is to have the 80% investment rule always apply for applicable funds and not just at the point of initial investment. Criteria for when an ETF's or fund's constituent holdings can diverge from the 80% rule will be specified by the SEC. |
Treatment of derivatives exposure in 80% rule | Since 2001, when the names rule was put in place, funds have increasingly used derivatives to execute their strategies. In the past, the Commission has interpreted the names rule to permit funds to include synthetic instruments, such as derivatives, in the fund’s 80% basket if the instrument has economic characteristics similar to the securities included in the 80% basket. However, the Commission has not specifically addressed how to include a derivatives instrument in that calculation. This, in turn, may have implications for whether a fund’s name accurately reflects the economic reality of the fund’s sources of returns and risk. The modified rule attempts to provide additional clarity on how derivatives exposure is calculated and reported in relation to the 80% rule. |
Enhanced disclosure and reporting requirements | Since 2001, there have been several changes in the industry such as increased electronic delivery of notices to shareholders and significant growth in the number of factor and thematic funds. The SEC addresses these issues in the context of the names rule through more specific disclosure around terms in the prospectus and new reporting items in Form N-PORT. |
Impact Of The SEC’s Proposed Names Rule Changes
Fund managers who have a high number of strategy or thematic funds where the 80% investment rule was not previously applied will be most impacted by these changes. In the past, the 80% investment rule was more strictly applied to funds whose names specified an asset class, sector or geography.
However, in the new proposal, the modified names rule will apply to any fund that has a specific investment characteristic, including factor-oriented funds (e.g., low volatility, dividend, growth or value funds) and thematic funds (e.g., ESG-, fintech- or infrastructure-themed funds). As per the SEC’s proposed changes, these funds will have to meet the 80% investment rule as well as the modified disclosure, reporting and recordkeeping requirements.
A significant number of ETFs and traditional mutual funds in the U.S. are likely to be impacted by the proposed modified names rule. To highlight this, the table below shows the count and aggregate assets of ETFs containing specific terms in their names.
For example, as of May 27, 2022, there were over 102 ETFs in the U.S. with over $72 billion in assets that have the term “ESG” in their names. There were 135 ETFs in the U.S. containing the term ”dividend” in the name of the ETF.
Table 2: Count and Aggregate Assets for ETFs Containing Specific Terms in Their Names
Terms in ETF Name | Number of U.S. Listed ETFs | Assets in U.S. Listed ETFs ($B) |
ETF name contains term ‘ESG’ | 102 | $72.7 |
ETF name contains term ‘dividend’ | 135 | $335.9 |
ETF name contains term ‘volatility’ | 47 | $27.8 |
Data: CFRA’s ETF database; data as of May 27, 2022
There are also several funds in the U.S. that use derivatives that will be impacted by the modified rule. In CFRA’s ETF database, there are over 410 ETPs in the U.S. with over $120 billion in aggregate assets that get their exposure primarily through derivatives.
The new rules are likely to result in a higher burden of name-related investment monitoring and disclosure for fund managers. However, from the perspective of investors, the proposed names rule changes should provide more transparency and accuracy in fund names, particularly for ESG oriented funds.
The SEC will accept public comments for 60 days after the proposed rule is published in the Federal Register, though the deadline could be extended. The proposal contemplates a one-year “transition period” for funds to come into compliance with any final rule changes.
Conclusions
The SEC’s proposed changes to the names rule section in the 1940 Act will extend the 80% investment rule to any fund whose name implies an investment with specific characteristics, including those with ESG-themed names.
Existing integration funds where ESG terminology is used in the name will need to ensure that ESG factors are significant determinants in the investment selection or remove such terminology to comply with the rule change. Funds that rely solely on keyword term analytics to assign companies to industries will also need to review their methodologies and/or terminology considering this rule change.
The proposed changes also strengthen prospectus disclosure and reporting requirements relating to the names rule. If the changes stand as proposed and come into effect after the proposed public comment and transition periods, they are likely to increase the disclosure burden for fund managers. However, from the perspective of investors, the proposed names rule changes should result in increased transparency in the names of funds regulated under the 1940 Investment Company Act.
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