Despite SEC Efforts, Accuracy in Fund Names Still Elusive

01/30/01 - 01:05 PM EST

For many, the name (LMVTX - Cramer's Take - Stockpickr)Legg Mason Value Trust calls to mind the only stock mutual fund that beat the S&P 500 index in each of the past 10 years. For others, however, the fund's name is a harsh reminder of the elasticity of fund names and the concept of value investing.

The Securities and Exchange Commission, which has long been frustrated by funds with misleading names, adopted a rule this month that purports to ban them. The problem is that it contains some large loopholes and may not apply funds such as Legg Mason Value.

The Value in Fund Names

Notwithstanding its value moniker, Legg Mason Value invested and performed like a growth fund during the 1990s, when growth funds outperformed their value counterparts annually by an average of almost five percentage points, according to Morningstar. Legg Mason Value's performance placed it in the top 1% of all value funds, which made it look like a good choice for investors betting on a rebound in value stocks in 2000.

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But Legg Mason Value was a bad bet in 2000, dropping to the bottom 8% among its value peers and losing 7.14% for the year. The (VIVAX - Cramer's Take - Stockpickr)Vanguard Value Index fund, which boasted a 6.1% return during the same period, about average for Morningstar's value category, would have been a much better bet for the value-minded.

Legg Mason Value's portfolio has hardly reflected the stocks with low price-to-book pricetobook and price-to-earnings pricetoearnings ratios you would expect to find in a value fund. According to Morningstar, at the end of 1999 its price-to-book ratio was 178% higher than the value category average, and its price-to-earnings ratio was 45% higher than average.

Value-seeking investors lured into the fund in early 2000 were hit with a double whammy. The fund sold many growth stocks, like America Online (now AOL Time Warner (AOL - Cramer's Take - Stockpickr)) and Dell (DELL - Cramer's Take - Stockpickr), that had generated its stellar performance in the 1990s. These sales resulted in not one, but two large taxable distributions in 2000.

The obvious lesson here is don't pick a fund by its name -- and read the prospectus. The description in Legg Mason Value's prospectus of the fund's "value discipline" approach is hard to follow, but its failure to refer to low P/E or price-to-book ratios suggests that its definition of a value stock might not be what you expect.

In contrast, the prospectus for the (VWNDX - Cramer's Take - Stockpickr)Vanguard Windsor fund plainly defines value stocks as those with prices that "typically are below-average in comparison to such factors as earnings and book values."

Not every investor reads the prospectus, however. Instead, "investors may focus on an investment company's name to determine the investment company's investments and risks," says an SEC release. And many funds use names like "U.S. Government Bond" or "North American Stock," yet their portfolios do not substantially reflect the securities suggested by these names.

The Misleading-Names Rule

That's why the SEC adopted the rule that prohibits the use of misleading fund names. Specifically, the rule provides that a mutual fund with a name that suggests that it will invest in a particular type of security must invest at least 80% of its assets in that type of security.

Previously, funds were required to invest at least 65% of their assets in securities suggested by their names. But this standard was only an SEC position. A fund could fall below the 65% minimum without technically violating any rule, so to sue the fund successfully the SEC had to prove that the name was misleading under general fraud principles. This is far more difficult than proving a violation of a black-letter rule.

Shareholders of the (ANAGX - Cramer's Take - Stockpickr)Alliance North American Government Income Trust learned about the problems of proof the hard way. In 1995 they sued the fund's manager, Alliance Capital Management, when the fund crashed, in part because it had invested 25% of its assets in Argentine securities. Nonetheless, last year the court dismissed the case, finding the fund's name was not misleading, in part because the Argentine investments did not violate the SEC's 65% standard.

Now that the rule is in place, the same Argentine investments may bring an SEC lawsuit. And courts in shareholder suits may be more likely to find the fund's name misleading.

Alliance did not respond to inquiries about its plans now that the rule has been adopted.

Although the rule simply requires what honest dealing and common sense would seem to demand, its path has been long and tortuous. In 1996, the SEC asked Congress for authority to address the growing problem of misleading fund names. Congress obliged, and the SEC promptly proposed the misleading-names rule in February 1997.

Under industry pressure, however, the rule died the death of a thousand cuts. The Investment Company Institute, the trade group for fund management companies, expressed concern that some terms were susceptible to more than one definition, and that the rule wouldn't provide sufficient flexibility to respond to market developments.

Some questioned whether 80% was too high for some types of funds and too low for others. Others argued that the rule would promote the use of uninformative generic fund names.

The misleading-names rule was resurrected last summer, when 12 groups, including my advocacy group, Fund Democracy, the Financial Planning Association, which represents 30,000 certified financial planners, the Consumer Federation of America, Consumers Union and Consumer Action petitioned the SEC to adopt the rule. The National Association of Investors Corporation, the AFL-CIO and the International Brotherhood of Teamsters have since filed similar petitions.

Not everyone supports the rule, however. Syndicated columnist Charles Jaffe derided it as "nonsense" in a column last month. His complaint? The rule will mean "more funds with names that have absolutely no bearing on strategy. That will not make investing in funds any easier."

Perhaps Jaffe finds it "easier" to make investment decisions based on fund names, but most people -- consumer groups, investor groups, financial planners, SEC commissioners and Congress -- agree that a fund's name is the last thing an investor should consider when choosing funds.

The Rule Already Needs Fixing

In fact, if anything the rule should be strengthened. For example, it isn't clear that it will even apply to Legg Mason Value Trust, because the SEC has questioned whether the rule should cover names when "a reasonable investor could conclude that the names suggest more than one investment focus." And the word "value" is arguably susceptible to more than one meaning.

But fund managers choose suggestive names precisely because the names do connote a commonly accepted, if not universal, meaning. Does anyone doubt that Bill Miller knows that most investors associate the term "value" with low price-to-earnings and price-to-book ratios?

If a fund chooses a name that includes a term that has a commonly accepted meaning, it's not much to ask that it invest accordingly, or simply use a name that isn't misleading.

Another problem is that the rule applies only under "normal circumstances." Managers may ignore the 80% limit "to avoid losses while assuming a temporary defensive position in response to adverse market, economic, political or other conditions," says the SEC. This standard is overbroad, as virtually any investment decision can be explained as an attempt to "avoid losses due to adverse market conditions."

The SEC should rein in this exception to the rule by setting time and percentage limits for temporary defensive positions and requiring a precise explanation in fund filings of what may qualify an adverse market condition.

A third problem is that the rule does not go into effect until July 31, 2002. If a fund's name is misleading today, why should it be allowed to use the name for another 18 months? The delay will surely please Alliance, which continues to thumb its nose at the SEC. At the end of September, its North American Government Income Trust had 25% of its assets invested in Argentine debt.

Although these loopholes, taken together, create significant gaps in the rule, it still will be a major improvement over current practice. Eventually funds such as Alliance North American Government Income Trust will have to change either their names or their investment practices.

And the rule is not a safe harbor. The SEC can still sue a fund for having a misleading name, even if it complies with the rule. But the problems of proof discussed above will make this exceedingly difficult.