The concept release is out. And the Securities and Exchange Commission wants to know: Just how much leverage should a mutual fund have?
The question is central to the regulation of uses of derivative securities by mutual funds that the SEC on August 31 opened to public comment. Many investors do not realize, chairman Mary L. Schapiro points out, that mutual fund managers, like other asset managers, use options, futures, and debt-based instruments not just as ways to hedge risks but to amplify returns. That is, gain leverage.
The question of how much leverage mutual funds should have is not simple, in a day when asset managers hold hundreds of trillions of dollars of assets whose worth is derived from other assets, such as securities, bonds, commodities or indexes. And whose permutations are nearly infinite.
And it’s not the only issue about derivatives opened up by the SEC. Also open to regulatory fiat: How should mutual funds value the derivative assets they hold and, how concentrated should their holdings be in any particular derivative or derivatives issued by any particular operating company or securities firm.
In any event, mutual funds are about to change how much leverage they can take on through derivatives – and maybe whether they can do so at all.
“The way the SEC is asking its questions,’’ said Todd Cipperman, managing principal of the mutual fund industry legal firm Cipperman & Co., “more regulation is on the way, if not outright prohibition” on the use of derivatives.
Funds use derivatives to help implement their overall investing strategies and tame risk. They can be used to “gain, maintain or reduce exposure to a market, sector or security,’’ as the SEC puts it. But they also entail risks, particularly in respect to the amount of debt held by a fund, also known as leverage, the liquidity of assets that are being held, and the risk that the party that created the derivative security may fail. That last is known as counterparty risk.
Among the variants that the SEC is seeking comment on are currency derivatives, which are used to increase or decrease exposures to different nations’ monetary strength; interest-rate derivatives, where, for instance, one party may try to hedge against the risk of a decline in the prices of bonds by swapping contracts in two different types of interest-bearing notes; credit derivatives, where a fund purchases protection against the default of a bond or some other adverse credit-related event; equity derivatives, where, for instance, a call option may be placed on a particular security owned by a fund.
The variants are indeed endless. There are futures, options, options on futures, swaps, forward swaps and even swaptions. The idea of buying (or selling) either exchange-traded derivatives (such as futures and options) or over-the-counter derivatives (such as swaps), at its heart, is to try and avoid the kind of volatility or disruption felt in portfolios by the typical swings in the values of stocks that are widely traded.
But the SEC is worried that investors do not have a clear idea of what kinds or amounts of derivative securities are held by mutual funds, on behalf of investors who think they are investing in stock or bonds or funds that invest in both, directly.
“The controls in place to address fund investments in traditional securities can lose their effectiveness when applied to derivatives,’’ said chairman Mary L. Schapiro, since derivatives were not around when the Investment Company Act of 1940 was passed.
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,’’ she said.
The problem is that fund managers cannot try to increase returns without increasing risk, according to George L. Stevens, chief compliance officer at the mutual fund advisory services firm Beacon Hill Fund Services.
Investing in debt or debt-related instruments is a way of multiplying the returns in a given set of holdings, he notes. “But it is also a way of ratcheting up the risk.’’
The SEC has not yet set out what it thinks is a reasonable amount of leverage – or risk-taking – in a fund portfolio.
But there are clues. For instance, existing law already restricts investment funds from putting more than 15 percent of their assets in “illiquid” investments. Stevens, for one, would be surprised if the SEC allowed mutual funds to place more than 25 percent of their holdings in derivative securities.
In addition, the SEC, in its concept release, notes that a “diversified fund” is a fund that “with respect to 75% of the value of its total assets (the “75% bucket”), has (among other things) no more than 5% of the value of its total assets invested in the securities of any one issuer.”
A non-diversified fund is any fund that does not meet these requirements, it says.
Making the whole issue of “leverage” trickier is the fact that derivative securities – indeed, many bonds themselves – are hard to value with great accuracy. Mortgage-backed securities, for instance, and other asset-backed securities can be particularly hard to put a price on. Which makes it hard to judge just how leveraged a fund is.
Derivatives can be priced at the market or “fair” value at which they could be expected to be sold off at, in the event of liquidation. Or they can be priced at the “notional” amount, which is the face value of the contract, times the number of units of the asset held.
But if the assets are overvalued, the fund’s level of risk may be understated. If undervalued, the risk overstated.
Plus, Stevens notes, the whole point of this exercise is to better disclose the risks that mutual funds choose to take on by the investments they make. Most investors on Main Street do not grasp the notion that bonds or investments based on different types or sets of bonds fluctuate in value, just like stocks, he says.
This likely will mean that, at the end of the day, mutual funds will have to better disclose not just how much leverage they take on with the derivatives they acquire, but just how they value what those securities are worth, Stevens maintains. Burying the tables that show the values or how they are attained will, in this case, be supplanted by clearer descriptions in text in the body of a prospectus or other document on what is held, how a value is arrived at and what that means for the overall risk – or leverage – in a fund.
Also subject to better disclosure will be the “divided risk,’’ as Stevens puts it, that is created when a derivative security is built, in the first place. If Morgan Stanley creates a swap based on an IBM obligation, the fund manager and the investor are taking on two types of risk, not one. The risk that Morgan Stanley could default and the risk that IBM might not perform, as promised.
So far, the Investment Company Institute, the primary trade group for mutual and exchange-traded funds, has not taken any stand on the concept release.
“We are reviewing the SEC’s concept release and look forward to submitting our comments,’’ the organization said last week.
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