Mutual Funds Face Curbs on Using Derivatives
The U.S. Securities and Exchange Commission is poised to take the first step toward writing new regulations on derivatives investments by mutual and exchange- traded funds, which hold more than $13 trillion in assets.
The agency’s four commissioners are scheduled to vote today to publish a set of ideas for new rules after conducting an industry review and warning investors of risks in funds that use derivatives to seek higher returns.
The SEC’s so-called concept release is expected to address questions about funds’ leverage and diversification, according to a person familiar with the matter who spoke on condition of anonymity because the proposal wasn’t yet public. The document would be open to public comment before the agency issues proposed rules.
The SEC has had to “twist like a pretzel” to accommodate financial tools such as derivatives in its regulations of funds, said Jay Baris, a New York-based partner at Morrison & Foerster LLP, and chairman of an American Bar Association task force that published a report last year on the issue.
“You have a set of laws that were, by and large, put in place long before anyone ever heard of derivatives,” Baris said in an interview.
The SEC, which has been writing derivatives regulations required under the 2010 Dodd-Frank Act, has also been reviewing how investment companies use the instruments. The agency last March said it wouldn’t approve new exchange-traded funds that make significant use of derivatives during the review.
That decision followed warnings to investors in 2009 by the Financial Industry Regulatory Authority, the U.S. brokerage watchdog that some types of ETFs might not be advisable for long-term investors. Under federal law dating to the 1940 Investment Company Act, mutual funds face leverage restrictions designed to limit shareholder losses.
The SEC said last year that it was concerned that mutual funds use generic disclosure forms providing “limited usefulness” to investors. Generic disclosures “may not enable investors to distinguish which, if any, derivatives are in fact encompassed in the principal investment strategies of the funds or specific exposures they will entail,” Barry D. Miller, associate director in the office of legal and disclosure at the SEC, said in a letter dated July 30, 2010.
Leveraged and inverse ETFs have received the most scrutiny from regulators for potentially confusing retail investors. The funds use derivatives to increase returns or have the opposite results returned by an index. Derivatives, including swaps, are financial contracts tied to an underlying stock, bond, index or event, such as the default of a company.
“I don’t think that they’re trying to constrain mutual funds or change the way they operate,” said P. Georgia Bullitt, partner at Morgan, Lewis & Bockius LLP. “I think they’re trying to make it safer and clearer.”
The SEC’s regulation of mutual funds’ use of derivatives is based on a 1979 agency release, known by the number “10666,” which didn’t specifically mention derivatives. That release was followed by a regulatory framework based on no-action letters and staff interpretations instead of new federal rules.
The bar association’s task force followed a 2009 speech by Andrew “Buddy” Donohue, the then-SEC director of investment management, in which he said he was most concerned by how derivatives affect the amount of leverage mutual funds have.
The bar association task force recommended that the SEC set out principles for funds to segregate accounts based on the risks of different types of derivatives.
“Mutual funds are severely limited in the amount of leverage they can use,” Mercer Bullard, president and founder of Fund Democracy, a mutual fund shareholder advocacy group based in Oxford, Mississippi. “There is no empirical evidence that derivatives in mutual funds pose a systemic risk or even that they’ve been responsible for significant losses relative to securities.”
In addition to the mutual fund concept release, the SEC may take up two other proposals: an advance proposal governing issuers of asset-backed securities, and a second concept release to seek public comment on the status of companies that acquire mortgages and mortgage-related instruments.
The five-member SEC board currently has one vacancy.
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