The Securities and Exchange Commission’s (SEC) rule 18f-4 set rules for the use of derivatives in 40-Act mutual funds in a 420-page release titled: “Use of Derivatives by Registered Investment Companies and Business Development Companies.”
Implicit in the language — and the title — is the notion that the SEC will allow 40-Act funds some room to use those risky derivatives products under certain conditions. In fact, previous rules on this were constructed in order to delineate the amount of derivatives. The idea being equity- based mutual funds were trading a great deal of S&P futures to hedge equity exposure. Its previous guidance in a way of speaking opened up a Pandora’s Box, which allowed clever industry participants to drive a truck through. This partially is responsible for the ability of managed futures programs to be reconfigured into a 40-Act product, which allowed it to be offered through a much broader distribution network.
Of course it wouldn’t have been necessary except for the fact that equity regulators did a pretty good job of making it quite difficult for commodity trading advisors to offer pooled products.
The misunderstanding, or lack of communication, is that it seems to overlook the new reality of managed futures funds. Derivatives are not a part of a portfolio, they are the portfolio.
The SEC’s rule is designed to provide an updated and more comprehensive regulatory approach to derivative use by funds: Rule 18f-4 would permit mutual funds and ETFs to enter into derivatives transactions provided that the funds comply with the conditions of the proposed rule. The proposed rule’s conditions are designed both to impose a limit on the leverage a fund may obtain through the use of derivatives and financial commitment transactions and other senior securities transactions, and to require the fund to have assets available to meet its obligations arising from those transactions, according to one analysis.
Benjamin Alpert, senior research engineer for Morningstar says, “The proposal if it stands as is, eliminates a huge amount of the ability for funds to use derivatives in portfolio management. He adds, “How I read this rule, managed futures funds would no longer be allowed to be in the 40-Act.”
Alpert points out that rule take two approaches to address the use of derivatives in 40-Act funds, both equally problematic. “[In] the commitment-based approach they use notional value as the measure of exposure no matter the instrument,” he says, noting that includes the use of interest rate swaps where you can never be responsible for the principal. “Technically you are swapping the payment flow tied to two principals on the couple. We would never see an interest rate shift of 5% or 10%, so even 5% or 10% of the notional is probably overstating the risk exposure.”
The risk-based approach only allows you to use derivatives if it reduces your value at risk (VaR) according to Alpert. “Imagine a bond portfolio today that has low duration bonds and wants to pick up duration by buying futures, they would not be able to because they would be increasing their value-at-risk by adding duration,” he says. “You end up forcing funds to either change their investment style or change how they execute portfolio management, it would encourage riskier behavior and it would apply to every bond fund.”
That is a complaint voiced in many comment letters (included throughout), that generally agree with the stated goals of the SEC but point out in detail how they get it wrong.
The rule is a big problem for managed futures mutual funds that generally are lower risk versions of the private placement commodity trading advisors (CTA).
It only allows 150% exposure, which is in line with the borrowing limitation of the 40-Act under the original rule that has been reinterpreted. Yes, the SEC is going back decades to reinterpret the original language. Of course, then there were no CTAs. As we pointed out above, the rules seem to treat derivatives as an annoying instrument that is better in small doses. They dont seem to recognize — or view as valid — that investment strategies relying solely on futures exist, or should.
“I don’t see how a managed futures fund can maintain less than 200% gross exposure and have a lower risk in their securities portfolio than in their futures exposure,” Alpert says.
Of course managed futures don’t have a securities portfolio other than the cash collateral they hold.
If you take a relatively low-risk diversified CTA that maintains a margin-to-equity ratio of 10%, and assume most futures margin is set at 5% of the notional value of a contract, a fund under those metrics would have 200% exposure. Most would have much greater exposure.
“This is a misunderstanding of portfolio management techniques that we see today. Perhaps there are some concerns that managed futures funds are not following the spirit of the 40-Act and are better suited for private funds or commodity pools,” Alpert says. “The [parameters] of the 40-Act protects investors, and putting these into liquid alts has been beneficial to the diversification opportunities for investors who might not otherwise qualify.”
A point illustrated well in numerous comment letters. While hundreds of industry sources have chimed in on the rule, the most qualified may be a White Paper penned by James Overdahl of Delta Strategy Group. Overdahl served as the Chief Economist at both the SEC and Commodity Futures Trading Commission. He writes:
“Alternative approaches that take risk into account can acheive the Commission’s goal of curtailing undue speculation and leverage in investment companies without depriving investors of the benefits of efficient access to low-volatility, low-correlation strategies achievable through the responsible use of derivative instruments. The proposing release does not adequately describe the costs of the proposed rule. The number of funds affected by the proposal is larger than contemplated in the cost benefit analysis in the proposal, and the impact of the rule falls disproportionately on investors in certain categories of funds such as intermediate-term bond funds, non-traditional bond funds, managed futures funds, and multi-alternative funds. The proposing release does not attempt to estimate or even recognize an important component of costs, namely the cost to investors of being excluded from investing in certain funds or categories of funds as a result of the restrictions of the proposed rule.
What seems to have changed in this proposal is the way the Commission looks at margin in the futures world.
“The way they are measuring the creation of borrowing for futures is narrow and the only exception is for hedging against a securities portfolio,” Alpert says. “So they are widening their scope of leverage — or synthetic leverage — that permitted only for funds that are using it for a purely hedging capacity. Not even for efficient portfolio management (EPM).”
He adds that the interpretation violates the notion of EPM. “EPM would say don’t cause anybody to enter into trades if you don’t have to, and the rule would cause a mixed asset portfolio of both physical and derivatives to roll physical position to riskier position and only use derivatives to reduce risk so you could never put on a risk-on trade and not incur transaction costs from selling your securities.”
One of the benefits of managed futures was that it did not use leverage. The leverage was imbedded in the margin requirements. Margin in securities means leverage whereas on the futures side, it has always been considered a performance bond. What appears to have happened is that the SEC is looking through the margining of futures — which are market to market daily — and consider it a form of leverage or borrowing.
Alpert says that from reading between the lines the regulators are following direction from Congress but this relates back to the original 40-Act. He suspects that some folks just realized that a no-action letter allowed managed futures to be offered through a 40-Act wrapper and don’t necessarily like it.
Taking a more measured approach is AQR, which could be one of the most adversely affected firms if the rule is approved as is. Here is what they had to say:
“The Rule would, if adopted as currently drafted, have far-reaching, negative implications for investor choice and the ability of investors to continue to access alternative mutual funds that are less correlated with equity markets. We expect that alternative mutual funds would be required to restructure their investment strategies, sometimes drastically, in a manner that will increase risks and reduce the benefits investors receive from such investments. The Rule would also generally limit the ability of investment companies registered under the 40-Act to appropriately manage their portfolios and invest in the lowest volatility instruments where appropriate through use of derivatives. Based on a study of just over 80% of the industry by the Investment Company Institute, the Rule would require retooling and, in some cases, possible closure of funds with over $600 billion in aggregate assets. The marked growth in alternative mutual funds since the crisis of 2008-2009 suggests to us that investors are diversifying some of their traditional equity risk by adding exposure to uncorrelated and less correlated sources of returns to their portfolios. We suggest that, particularly in a world that many view as having lower prospective returns to traditional asset classes but enormous needs from individual investors who now shoulder more of their own retirement burdens, it could prove counterproductive to adopt a rule that would necessarily close some alternative mutual funds or cause them to be significantly revamped in ways that would result in more risk concentration, higher costs and less effectiveness.
AQR included some examples (see “Where to reduce risk,” above) of why the SEC rule could be adding risk by reducing the ability to invest in alternates. They also included some recommendations on how to “fix” the rule (see “Just a little tweak,” below).
AQR offers just one of several amendments to make the rule palatable and not force a mass exodus of funds from the 40-Act structure. Alpert favors a European approach. “You set an absolute level of VaR at a percentage of fund net assets over a specific time period. If you are adopting a risk management approach with derivatives and you use that VaR, that is what they are measuring. They don’t have to measure it before and after derivatives. You just have to get a VaR on the portfolio and the max loss in the specific time period is below the threshold at the confidence interval that they prescribe,” Alpert says.
While most comments were cordial, even complimentary, of the SEC’s efforts, the proposal if passed could seriously inhibit these products.
Alpert wouldn’t go so far as to say the purpose of the rule is to prevent retail investors from accessing alternatives, but he adds, “If this rule is implemented in the way it has been proposed, then that would be an unintended consequence.”