What’s in a name? Quite a bit, according to the Securities and Exchange Commission.
The regulatory body is considering a crackdown on funds with misleading or deceptive names by updating the names rule it enacted in 2001, it said in a Monday announcement. The move could spell trouble for funds with names like Best Returning Derivatives Fund LP.
It’s been nearly twenty years since the names rule was adopted (which, coincidentally, happened just a couple of years after the bailout of Long-Term Capital Management — perhaps the most misleading fund name of all time). The rule prohibits funds from using misleading names and requires funds to allocate at least 80 percent of their assets to the investments they are named for.
Since then, no amendments have been made to the rule, according to the SEC.
“This request for comment is another important step in our efforts to better inform and protect Main Street investors and improve the investor experience,” said SEC Chairman Jay Clayton in a statement.
The SEC is zeroing in on a few issues that may have arisen since the rule was originally enacted, according to its request for comments document.
Derivatives funds, for example, have grown in popularity in recent years, according to the SEC. That framework, according to the SEC, may not be the best measure “when the market values of derivative investments held by funds are relatively small but the potential exposure is significant.”
The increasing popularity of hybrid financial instruments may also have resulted in misleading fund names, according to the SEC. Some funds, for instance, may invest in convertible securities that can behave like equity or debt securities depending on the markets, per the SEC.
“Staff has observed that both debt and equity funds include convertible securities as part of their 80 percent investment policies,” the SEC said. This is one of several challenges the SEC identified.
Similarly, the increasing prevalence of funds based on indexes could pose a problem for the SEC. At present, indexes are not investment companies, which means they are not subject to the names rule. The SEC said its staff has found that indexes may not always be “closely tied” to the investment strategy suggested by their names.
Environmental, social, and governance investments are also presenting a challenge for the SEC. The SEC said that its staff has noted that some funds treat ESG as an investment strategy rather than a type of investment, which means that the names rule doesn’t apply, nor does the 80 percent investment policy.
The SEC said its final concern is what is happening in an “increasingly competitive market environment,” as asset managers try to use new fund names to differentiate themselves from others.
Research has shown that fund names play a major role in attracting capital: Hedge fund investors allocate more money to funds with names that connote “gravitas,” according to one study from researchers at the University of Oulu in Finland and University at Buffalo’s School of Management.
[II Deep Dive: Hedge Funds with Strong, Powerful Names Attract the Most Money]
“This incentive may drive managers to select fund names that are more likely to attract assets (such as names suggesting various emerging technologies),” according to the SEC.
Interested parties have 60 days to submit comments to the SEC on potential changes to the names rule.
“We are looking to investors and market participants for input on how our framework can be improved to help ensure that fund names inform and do not mislead investors,” Clayton said in a statement.