Funds Provide Inadequate Disclosure on Derivatives, SEC Says
U.S. regulators said mutual funds aren’t telling investors enough about why they use derivatives, with some funds providing “generic” disclosures and others failing to explain how the products affect performance.
Regulators said they are concerned that the use of derivatives has increased in the mutual-fund industry without shareholders comprehending the risks or investment strategies. Some funds offer information that “may not be consistent with the intent” of required registration forms, the Securities and Exchange Commission wrote in a July 30 letter to the Investment Company Institute, the industry’s biggest trade group.
The SEC also raised concerns about “abbreviated” disclosures that give investors a false sense of security about how much funds rely on derivatives.
“While more abbreviated disclosures could lead some investors to believe that a fund’s exposure to derivatives is minimal, we have observed that some funds employing this type of disclosure, in fact, appear to invest significantly in derivatives,” wrote Barry Miller, an associate director in the SEC’s division of investment management.
As a result of the inadequate disclosures, investors may not know which products are used to generate profits, Miller said in the letter. He advised all funds that use derivatives to “assess the accuracy and completeness” of their disclosures.
Working with Members
The ICI “is reviewing the SEC staff’s letter on derivatives-related disclosures,” said Rachel McTague, a spokeswoman for the Washington-based group. “We will work with our members to ensure that they understand and comply with their disclosure obligations.”
Derivatives are securities whose value is linked to assets such as stocks, bonds or commodities. Congress last month increased regulation of the products after transactions tied to the U.S. housing market were blamed for triggering the financial crisis and the near-collapse of companies including American International Group Inc.
Regulators have previously said they were particularly focused on leveraged and inverse exchange-traded funds, which rely on swaps to amplify profits or post inverse returns to an index. Such strategies enable funds to get around restrictions on borrowing implemented under the 1940 Investment Company Act.
The SEC announced in March it wouldn’t approve new ETFs that make significant use of derivatives until the agency completes an examination of the practice. While the review is ongoing, the SEC’s Miller said the agency wanted to inform the industry of some of its initial observations.
“We believe these observations may give investment companies immediate guidance to provide investors with more understandable disclosures,” Miller wrote in his letter to Karrie McMillan, the ICI’s general counsel.
To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.
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