Bloomberg News

Mutual Funds May Face Curbs on Derivatives to Boost Returns

August 31, 2011

(Updates with vote in second paragraph, Schapiro comment in third paragraph.)

Aug. 31 (Bloomberg) -- The U.S. Securities and Exchange Commission took a first step toward writing new regulations for use of derivatives in investments by mutual and exchange-traded funds that hold more than $13 trillion in assets.

SEC commissioners voted 4-0 today to seek comment on a set of ideas for updating the Investment Company Act of 1940 after beginning an industry review and warning investors of risks in funds that use derivatives to seek higher returns.

“The controls in place to address fund investments in traditional securities can lose their effectiveness when applied to derivatives,” SEC Chairman Mary Schapiro said during the meeting in Washington. “This is particularly the case because a relatively small investment in a derivative instrument can expose a fund to a potentially substantial gain or loss -– or outsized exposure to an individual counterparty.”

The SEC’s so-called concept release seeks response to questions about funds’ leverage, diversification and valuation of holdings in derivatives. Today’s vote will open the agency’s release to public comment for 60 days after its publication in the Federal Register.

‘Like a Pretzel’

The SEC has had to “twist like a pretzel” to accommodate financial tools such as derivatives in its regulations of funds, Jay Baris, a New York-based partner at Morrison & Foerster LLP, said in an interview before the meeting.

“You have a set of laws that were, by and large, put in place long before anyone ever heard of derivatives,” said Baris, who was chairman of an American Bar Association task force that published a report on the issue last year.

The SEC, which has been reviewing how investment companies use derivatives, said in March 2010 that it wouldn’t approve new exchange-traded funds that make significant use of the instruments until the review was completed.

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 the Investment Company Act, mutual funds face leverage restrictions designed to limit losses.

‘Limited Usefulness’

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 SEC’s investment management unit, said in a letter dated July 30, 2010.

U.S. mutual funds had $12.2 trillion in net assets in June, while exchange-traded funds had $1.1 trillion in July, according to the Investment Company Institute, a Washington-based trade association.

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 law firm Morgan, Lewis & Bockius LLP. “I think they’re trying to make it safer and clearer.”

1979 Release

The SEC’s regulation of use of derivatives by mutual funds is based on a 1979 agency release that didn’t specifically mention derivatives. That release was followed by a regulatory framework based on no-action letters and staff interpretations instead of new rules.

The bar association’s task force followed a 2009 speech by Andrew “Buddy” Donohue, then serving as director of the SEC’s investment management unit, in which he said he was most concerned by how derivatives affect the amount of leverage mutual funds have.

The 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.”

Asset-Backed Securities

The SEC will also weigh public comments in an agency reexamination of regulatory exemptions for some issuers of asset backed securities and real estate investment trusts. In unanimous votes at the same meeting today, the commission opened 60-day comment periods on potential changes to the Investment Company Act that could tighten rules for obtaining exemptions.

“This is important because an entity that is excluded from this definition is exempt from the requirements of the Investment Company Act,” Schapiro said. “Among the ideas we discuss is requiring an ABS issuer to undergo an independent review to protect investors in asset-backed securities from self-dealing and overreaching by insiders.”

The five-member SEC board currently has one vacancy.

--With assistance from Christopher Condon in Boston. Editors: Gregory Mott, Lawrence Roberts

To contact the reporter on this story: Silla Brush in Washington at

To contact the editor responsible for this story: Lawrence Roberts at

Too Cool for Crisis Management
blog comments powered by Disqus