Funds’ Portfolios Must Reflect Their Name, SEC Says

The Securities and Exchange Commission finalized a new rule Wednesday which will require investment funds whose name suggests investments with “particular characteristics,” ranging from environmental, social and governance to artificial intelligence, to have at least 80% of their value in securities that correspond to that name.

Before the new rule, the only funds required to follow an 80% rule were those whose name evoked a “specific type of security,” such as ‘equity’ or ‘bonds,’ “and not a strategy,” such as ‘growth’ or ‘value,’ says Abigail Hemnes, a partner in K&L Gates’ asset management and investment funds practice. Index funds were likewise already subject to an 80% rule.

Fund names previously not subject to the names rule were subject only to the “general anti-fraud provisions of the federal securities laws,” Hemnes explains.

Besides names that evoke a strategy, any name that suggests the fund focuses on a particular geographic region, industry or goal must also follow an 80% policy, according to the SEC.

During Wednesday’s open hearing in which the rule was approved by a 4-1 vote, SEC Chairman Gary Gensler said that a fund name that includes “AI or big data” would need to have 80% of its value in securities that reasonably fit that description.

Growth vs. Value

Amanda Wagner, the senior special counsel for the SEC’s division of investment management, explained during the hearing that funds have flexibility to reasonably define the terms in their name. SEC Commissioner Hester Peirce asked Wagner if one fund classifies a security as “growth” and another fund classifies it as “value,” is one necessarily violating the names rule? Wagner answered, “Definitely not,” provided the security could plausibly fall into either category.

Peirce also asked Wagner if a fund calling itself a “green car” fund could legally invest in high-efficiency gas-fired vehicles and not electric vehicles. Wagner answered yes, because that was a reasonable interpretation of “green car,” as that phrase has no “universal definition.” The fund certainly could not call themselves an electric car fund, Wagner added, and the fund would still have to define what it meant by “green” in its prospectus and disclose which securities it was counting toward 80%.

Wagner also noted that funds with compound names can reach 80% by adding the items together. Hemnes says that this would apply to ESG labeled funds, because they could keep the label, as long as ESG values added up to 80%. The fund would still have to define each term and disclose the exact criteria used to select investments described by the terms, she notes.

ESG Considerations

The initial proposal would have made ESG integration funds all but impossible to name ‘ESG,’ because it would have banned funds that do not use ESG considerations as a primary factor from using the label in their name. The final rule rolls this back, according to Hemnes: “ESG integration funds can still use an ESG term in” their names.

Andrew Behar, the CEO of As You Sow, a non-profit that promotes corporate social responsibility, said in an emailed statement that, “Under the proposed rule, if funds considered ESG factors, but such ESG factors were not the principal purpose of the fund’s investment strategy, it would have been materially deceptive and misleading to use ESG or a similar term (such as sustainable, green, impact, etc.) in the name. This section was left out of the final rule.”

Behar says that many funds take advantage of the remaining 20% in their portfolio in ways that can be “misleading.” He specifically cited funds that use environmental goals in their names but include coal companies in their portfolio. Behar says the final rule is a step in the right direction but ultimately will not end misleading labeling, “as long as you are 80% of what you say you are.”

If a fund falls below the 80% threshold, it will have 90 days to come back into compliance. The proposal, published in May 2022, initially gave funds only 30 days.

Funds greater than $1 billion in value will have 24 months after the rule’s effective date to comply, and those smaller will have 30 months. The effective date is 60 days after the rule is entered into the Federal Register.