Fund Valuation Under the SEC’s New Fair Value Rule

Fund Valuation Under the SEC's New Fair Value Rule

DECEMBER 2021

W A S H I N G T O N , D C // L O N D O N // B R U S S E L S // H O N G K O N G // W W W . I C I . O R G

Contents

1 I.Introduction

3 II.Range of Fund Investments and Their Varied Valuation Methodologies

6 III.Key Contributors to the Fund Valuation Process 6 A.Fund Boards 9 B.Investment Advisers 11 C.Key Third Parties

15 IV.The Role of the SEC and Its Staff

17 V.Rule 2a-5's Core Requirements 17 A.Assessing and Managing Valuation Risks 18 B.Establishing and Applying Methodologies 21 C.Testing Methodologies 24 D.Evaluating Pricing Services

28 VI.Conclusion

30 Appendix: Summary of Legal Requirements and Accounting Standards Affecting Fund Valuation 30 A.General Obligations Under the Investment Company Act and Its Applicable Rules 32 B."Fair Value" Under GAAP 33 C.Reporting Obligations and Accounting Standards 35 D.Registration Statement Disclosure Requirements 35 E.Money Market Funds 36 F.Closed-End Funds

Gregory Smith, senior director of fund accounting and compliance, and Matthew Thornton, associate general counsel, authored this report; Dorothy Donohue, deputy general counsel, and Rachel Graham, associate general counsel, provided editorial assistance; and Christof Stahel, senior economist, and Irina Atamanchuk, research assistant, provided research assistance.

The Investment Company Institute (ICI) is the leading association representing regulated funds globally, including mutual funds, exchange-traded funds (ETFs), closed-end funds, and unit investment trusts (UITs) in the United States, and similar funds offered to investors in jurisdictions worldwide. ICI seeks to encourage adherence to high ethical standards, promote public understanding, and otherwise advance the interests of funds, their shareholders, directors, and advisers. The content contained in this document is proprietary property of ICI and should not be reproduced or disseminated without ICI's prior consent. Copyright ? 2021 by the Investment Company Institute. All rights reserved.

Fund Valuation Under the SEC's New Fair Value Rule

I.Introduction

Funds'1 valuation practices are guided by the Investment Company Act of 1940 (Investment Company Act), the valuation-related rules thereunder, and accounting standards. Section 2(a)(41) of the act establishes a two-pronged approach to valuing portfolio investments:

? securities for which market quotations are readily available must be priced at market value; and

? all other securities must be assigned a "fair value as determined in good faith by the board of directors" of the fund.

Most funds value each of their portfolio investments every business day. This is a necessary step in a fund's daily calculation of its net asset value (NAV). A fund then uses its NAV to process daily purchases and redemptions by fund shareholders.2

A well-functioning valuation process is critically important to funds and their shareholders. As the Securities and Exchange Commission (SEC) has stated, "Proper valuation, among other things, promotes the purchase and sale of fund shares at fair prices, and helps to avoid dilution of shareholder interests. Improper valuation can cause investors to pay fees that are too high or to base their investment decisions on inaccurate information."3 Proper valuation also helps ensure accurate total return performance calculations, which are based on the change to a fund's NAV.

As of September 30, 2021, funds registered under the Investment Company Act held $32.5 trillion in assets. Funds hold a wide array of portfolio investments, including equities, fixed-income securities, and derivatives--valuing them requires a variety of processes, methodologies, inputs, and assumptions.

1 In this report, we will refer to mutual funds, exchange-traded funds (ETFs), closed-end funds, and business development companies (BDCs) as funds.

2 Open-end funds, which include mutual funds and ETFs, value their portfolios each business day, from which they calculate the NAVs used to process daily purchases and redemptions by fund shareholders. Closed-end funds and BDCs must periodically value each of their portfolio holdings, with most closed-end funds choosing to do so every business day. Closed-end interval funds resemble open-end mutual funds in that their shares are continuously offered and typically priced daily to facilitate investor purchases. See the appendix for additional detail.

3 Good Faith Determinations of Fair Value, SEC Release No. IC-34128 (Dec. 3, 2020) ("Fair Value Release"), available at rules/final/2020/ic-34128.pdf.

Fund Valuation Under the SEC's New Fair Value Rule // 1

Within the framework of the Investment Company Act, valuation practices have evolved over the decades in response to:

? the changing investment landscape, as evidenced by the increase in number and type of funds' portfolio investments;

? changes to market structure; ? enhanced data availability, including the development of the Financial Industry

Regulatory Authority (FINRA) Trade Reporting and Compliance Engine (TRACE);4 ? changes to accounting standards, including the development of Accounting

Standards Codification Topic 820, Fair Value Measurement (ASC Topic 820); and ? other relevant legal and regulatory actions, including the enactment of the

Sarbanes-Oxley Act of 2002 and adoption of rules thereunder, and adoption of Rule 38a-1 under the Investment Company Act (the "compliance rule") in 2003.

In December 2020, the SEC adopted Rule 2a-5 under the Investment Company Act (the "fair value rule," or the "rule").5 Motivated by the cumulative impact of the changes mentioned above, this rulemaking is the SEC's most comprehensive and significant action on fund valuation in 50 years.6 Funds must comply with this new rule (and companion recordkeeping Rule 31a-4) by September 8, 2022.

Given the importance of this new rule and fund valuation generally, we have prepared this report to examine fund valuation practices. In the sections below, we discuss or describe:

? the range of funds' portfolio investments and how they are valued; ? the key parties that contribute to fund valuation; and ? the core requirements of the fair value rule and how they compare to current

industry practices.

The appendix summarizes the legal requirements and accounting standards that govern and shape fund valuation.

We believe this report also makes clear the rigor with which fund advisers, boards, and key third-party service providers carry out their work.

4 TRACE is the FINRA-developed vehicle that facilitates the mandatory reporting of over-the-counter (OTC) transactions in eligible fixed-income securities. All broker-dealers that are FINRA member firms have an obligation to report transactions in TRACE-eligible securities under an SEC-approved set of rules.

5 See supra, note 3. 6 Further explaining the purpose of this rulemaking and its approach, the SEC states, "The final rule establishes

minimum and baseline standards that we believe are inherent in any good faith fair value determination, as informed by current industry practice." Fair Value Release at 10. ICI's comment letter on the 2020 proposal was generally supportive of the new framework. Overall, we believed it would improve and modernize the regulatory framework for fund valuation of portfolio securities; appropriately reflected the roles of fund boards and investment advisers; and correctly recognized the importance of accounting standards to funds' fair value determination process.

2 // Fund Valuation Under the SEC's New Fair Value Rule

II.Range of Fund Investments and Their Varied Valuation Methodologies

Funds invest in a wide range of equities, fixed-income securities, and derivatives. To provide a measure of this variety and volume, ICI evaluated and aggregated the portfolio holdings data contained in each reporting fund's last publicly disclosed Form N-PORT filing made in 2020.7 In the aggregate, these 12,838 fund filings reported 505,390 unique investments in their portfolios, distributed across broad asset classes8 as follows:

? Debt: 178,314 ? Asset-backed securities: 146,027 ? Derivatives: 117,415 ? Equities: 47,136 ? Loans: 8,095 ? Short-term investment vehicles: 2,916 ? Repurchase agreements: 2,700 ? Commodities: 49 ? Real estate: 4 ? "Other": 654 ? "No" asset type: 2,080

Given this variety and volume, it is not surprising that funds use various valuation methodologies, with varying inputs, assumptions, and complexity.

As discussed in more detail in the appendix, when pricing an asset or liability, market participants use data and assumptions as inputs. Inputs form the basis of the US Generally Accepted Accounting Principles (GAAP) fair value hierarchy, which is used to categorize the fair value measurement for a portfolio investment into one of three levels.

Level 1. For a fair value measurement to qualify as a Level 1 measurement in the fair value hierarchy, or for an input into a fair value measurement to qualify as a Level 1 input, the price (input) must be a quoted price (unadjusted) in an active market for an identical asset that the fund can access at the measurement date. An active market is a market in which transactions for the asset take place with sufficient frequency and volume to provide pricing information on an ongoing basis. The fund must be able to access the price at the measurement date. For example, a fund has access to the price if it has the

7 We restricted our analysis to reporting funds (i.e., those funds that make Form N-PORT filings) of ICI members. Because reporting funds' fiscal year-ends differ and not all fund filings are publicly available, we could not review and aggregate the data as of a single date.

8 We aggregated this information from funds' responses to Item C.4.a on Form N-PORT, and we further categorized the information to correspond to these 11 categories. "Other" includes investments that were not reported under one of the form's more specific categories, such as registered investment companies and private funds (among others). We have classified an investment as having "No" type in cases where funds classified it differently and there was no strong preponderance of evidence suggesting that a particular classification was likely to be correct (Form N-PORT has no corresponding classification option).

Fund Valuation Under the SEC's New Fair Value Rule // 3

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download