Fund management companies have expressed opposition in recent weeks to elements of a Securities and Exchange Commission proposal in December to limit the use of derivatives by mutual funds and exchange-traded funds, complaining that the proposed rules go too far.
Derivatives are commonly used by liquid alternative mutual funds, which seek to replicate hedge fund strategies, and by ETFs designed to move two or three times the magnitude of a security, commodity or index. Liquid alternative mutual funds have attracted $156 billion of investors’ money over the past five years, according to Morningstar.
“We endorse the rule, but in some parts it can do better,” says Barbara Novick, vice chairman of New York–based asset manager BlackRock. “The goal of the rule is to limit derivatives and leverage and have some control in the system. We support that goal.” The problem is implementation, she says. “The proposal won’t achieve the results of some of its goals.”
Fund managers object mostly to three provisions of the SEC proposal: First, funds must limit their derivative exposure to 150 percent of assets or 300 percent of assets if they pass a value-at-risk test. Second, funds must generally segregate cash equal to the sum of the amount the fund would pay if it were to exit the derivatives transaction at the time of the determination, plus an estimate of what the fund would pay if it were to bail out under stressed conditions. And third, funds using derivatives extensively must create a risk management program administered by a designated derivatives risk manager.
The proposal was announced in December, and the final public comment was posted April 8. It could take months for the SEC to decide what, if any, regulation to enact. Agency officials declined to comment on the issue.
The linchpin of fund companies’ objections is that the SEC’s proposal doesn’t properly deal with risks arising from derivative use. “Vanguard strongly recommends that the SEC apply a risk-sensitive approach to the proposed portfolio limits on derivative transactions, to more appropriately address the investor protection and undue speculation concerns,” says Vanguard Group spokesman David Hoffman.
The exposure limit is determined using the gross notional aggregate of a fund’s derivative exposure. But fund companies say that measurement is inadequate. “The problem is that it doesn’t tell you anything about risk,” Novick says. The gross notional aggregate equally weights Eurodollar futures, which have very little market risk, with 20-year Treasury futures, which have much greater market risk. “There is also no credit given to a manager who might be hedging risk,” she says. “Gross notional exposure is too simplistic.”
Moreover, fund companies see no reason to restrict segregated assets to cash and cash equivalents. “We believe that there are other types of liquid assets that could be used to satisfy a fund’s future contingent obligations and are consistent with rules adopted by other regulators,” T. Rowe Price wrote in a letter to the SEC commenting on the proposal.
For example, when executing swaps, funds can use Treasuries, other government securities, S&P 1500 stocks and gold as segregated assets. A haircut is applied to each asset based on how much of a discount the fund would have to absorb in the event of a sale under adverse conditions. The riskier the asset, the greater the haircut.
Limiting the segregated assets to cash can distort the composition of a fund’s portfolio, Novick says. “In a world where liquidity is scarce, do you want to tie up cash in that way when there’s another way that’s more flexible?” she says.
On the risk management front, fund managers told Morningstar analysts that the rule will force them to formally evaluate each trade, rather than their overall positions on a daily basis, as they do now, requiring an inordinate amount of time, says Scott Cooley, director of policy research for the Chicago research firm. “Managers say that’s impractical.”
He says the proposal may have the perverse consequence of increasing risk. That’s because, he says, it encourages funds to take more risk with the “physical side” of the portfolio and then use derivatives to reduce that risk.
“Funds could end up taking more risk and using more derivatives than they would without the rule,” he says. The SEC’s goal is to lower overall risk, which Morningstar supports. “But the way the rule is written, we don’t think that’s what portfolio managers would do.”
To be sure, not all shareholder advocates share Morningstar’s opposition to the proposal. The Consumer Federation of America is one of its supporters. “The proposal will better protect investors from the risk derivatives pose to funds and lessen the chance that funds will blow up when derivatives go bad,” says Micah Hauptman, financial services counsel for the group.
He notes that few mutual funds use significant amounts of derivatives. Only 29 percent of traditional mutual funds utilize them at all, according to the SEC’s estimate. And just 27 percent of liquid alt funds have a notional derivative exposure that totals at least 150 percent of their assets, which would subject them to the proposed rule. Using Morningstar’s tally of 607 liquid alt funds, that 27 percent would constitute 164 funds.
Still, the few funds that have loaded up on derivatives have “deviated from what they were originally intended to do, which is hold securities,” Hauptman says. Funds should be allowed to use derivatives to amplify returns or mitigate risk. “But they have to be used with appropriate safeguards,” he adds.