SEC Proposals: Ironic Harm to Mutual Funds?

Mutual Funds scrabble artRegulatory changes for financial services are common.  The environment is ever-changing, especially in periods following large market fluctuations.  These market disruptions offer a prime opportunity for regulators to propose new rules in an attempt to prevent similar failures.  A perfect example is the financial crisis of 2008 which resulted in Dodd-Frank.  Dodd-Frank’s new rules centered on capitalization requirements to prevent similar events.  Now, regulators are currently proposing rules that could change the mutual fund universe.

Recent proposed fiduciary standards from the SEC requiring representatives to select investments in the best interests of investors (similar to the Labor Department’s recent fiduciary rule for retirement advice) may limit the ability to sell share classes with higher expenses or load commissions.  This could result in many different mutual fund classes ceasing to exist.

The SEC is also prosing rules regarding risk and risk management, in particular the use of derivatives.  They are concerned about liquidity and leverage with many of the Dodd-Frank provisions resulting in fewer “market-makers” and less liquidity in the market place.  According to some credit portfolio managers, there is less liquidity in the marketplace than at any time in their careers.  This results in investors or their advisors seeking higher returns in the low interest rate environments and ultimately investing in bonds with higher risk and lower liquidity.

Due to the 2008 financial crisis, investors wanted to cushion their portfolios against market volatility, which resulted in the creation of liquid-alternative funds (i.e. liquid alts or non-traditionals) that used derivatives.  (Liquid alts / non-traditionals are investments that extend beyond traditional asset classes – such as public equities and fixed income – and long-only investing strategies in order to provide diversification and non-correlated returns. Hedge funds and private investments fall into this category.)

These non-traditional funds may be the most affected by proposed regulations.  Should the new regulations become a reality, these non-traditional fund managers may be forced to prove that their derivative exposure does not lead to excessive leverage.

The managers who invest in derivatives would be required to create a Chief Risk Officer (CRO) position who would report to the board of the investment company.  The CRO would create a system to manage risk and develop reporting infrastructures that would be reviewed by the board.  This information could also be reviewed by regulators.  The CRO would be responsible for making sure the derivative exposure is in line.

At a time when investors are seeking passive investments, which is creating demand for lower mutual fund fees, it is possible that these new regulations could cause the mutual fund industry to incur higher expenses making it difficult to keep costs low.  Mutual fund managers are integral to the investment community.  Regulators will need to find the right balance in managing risk and not constraining mutual fund companies too tightly; allowing useful strategies like non-traditionals to continue to be a viable solution for investors.






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