SEC Exam Trends

The SEC’s Division of Examinations has conducted a series of exams, coined as the Retail Investment Company Initiatives (RIC), which focused on mutual funds and exchange-traded funds (ETFs). This initiative concentrated on advisers that fell into the following six categories: (1) index funds that track custom-built indexes; (2) smaller ETFs and/or ETFs with little secondary market trading volume; (3) mutual funds with higher allocations to certain securitized investments; (4) mutual funds with aberrational underperformance relative to their peer groups; (5) mutual funds managed by advisers that are relatively new to managing such funds; and (6) advisers that provide advice to both mutual funds and private funds, both of which have similar strategies and/or are managed by the same portfolio managers.

In general, the initiative aimed to assess the effectiveness of compliance policies and procedures for funds and their advisers, disclosures by the funds to investors, and fund governance practices.

When looking at these areas, the SEC identified the following deficiencies or weaknesses:

Compliance Program

Funds and their advisers did not establish, maintain, update, follow or tailor their compliance programs to address:

• Portfolio Management: trade allocation, best execution, investment restrictions, asset classes, and liquidity risk management programs for each fund
• Valuation: due diligence of pricing vendors, policies relating to where portfolio managers are permitted to provide input on prices of securities in funds they manage
• Trading: trade allocation among similarly situated accounts, equal opportunity for both fund and non-fund clients, monitoring principal transactions, identifying cross trades, addressing soft dollar commissions among clients to determine whether any client is disadvantaged
• Conflicts of Interest: addressing adviser’s COIs with funds and their service providers, reviewing index providers and the services they provide for things such as advisers’ affiliations and misuse of MNPI
• Fees and Expenses: monitoring allocation of expenses between funds and their advisers, fee calculations with inconsistencies between the fund’s contractual expense limitation and its disclosures regarding expenses
• Advertising: review of fee/expense disclosures to ensure they are not misleading in their context, reviewing affiliated index providers’ websites to assess whether the websites may be deemed fund advertisements

Fund policies and procedures and their boards’ oversight of the fund’s compliance program did not:

• Have appropriate policies for monitoring and reporting accurate information to the board, particularly regarding fees paid by the fund to service providers, the types of services provided to the fund, pricing exceptions, adviser’s recommendation whether a fund’s liquidation may be in the best interest of the fund, and portfolio compliance with senior securities
• Provide appropriate processes for the respective fund board’s annual review and approval of the fund’s investment advisory agreement
• Complete required annual reviews of the fund’s compliance program
• Ensure the annual report from the fund’s CCO included policies, procedures, and specific risk areas
• Adopt policies and procedures necessary for the fund’s board to provide oversight in situations where the fund has assigned responsibilities to their advisers that were not reflected in the compliance program

Disclosures to Investors

Funds had inaccurate, incomplete, and/or omitted disclosures in their filings, such as:

• Omitting disclosures regarding investment strategies, potential conflicts, and changes in the board-based indexes used for comparison of funds’ performance
• Inconsistent or inaccurate disclosures concerning fund’s net assets and net expense ratios, contractual expense limitations, and operating expenses
• Failed to disclose the fund’s SAIs required information concerning information on the number of accounts and total assets
• Other areas such as: investment strategies, portfolio holdings, predecessor vs successor objectives, inception dates, awards received, composition of index used for performance comparisons

Practices the SEC observed and found to be helpful for some funds and their boards

• Review of compliance policies and procedures seeking consistency with practices
  Conducting periodic testing and reviews for compliance with disclosures, assessing effectiveness of compliance policies and procedures for addressing COIs
• Conducting periodic testing and reviews for compliance with disclosures, assessing effectiveness of compliance policies and procedures for addressing COIs
• Ensuring compliance programs adequately address oversight of vendors and service providers
• Adopting and implementing policies and procedures to address compliance with regulations and undisclosed COIs between the fund, their adviser and their service providers
• Oversight of compliance programs was assessed by seeing that:
  • Information provided to the board was accurate including the fees, expenses, and performance as well as the investment strategies and any changes or risks associated
• Policies and procedures concerning disclosures that required:
  • Reports and other communications were consistent with the fund’s investment policies and restrictions
  • Amendments to disclosures, including to the fund’s website, were timely given any actions taken by the fund’s board
  • Review and testing of fees and expenses were disclosed in the fund’s reports and client communication
  • Review and testing of the fund’s performance advertising for accuracy

The SEC recommends and encourages advisers to review their practices, policies, and procedures in these areas and consider improvements in their compliance programs and disclosures, as appropriate.