Last August, the SEC issued a Concept Release and request for comments on the subject of derivative usage in mutual funds, as the first step in what could potentially be significant new regulations in this area. It seems likely that the SEC will propose new standards for derivative usage in funds within the next year, although it's still unclear how sweeping those changes might be.
Eileen Rominger, the director of the SEC's division of investment management, has signaled that the impact of the review will not be draconian. "The fundamental issue is that mutual funds use derivatives responsibly, consistent with their investors' expectations, and with the backdrop of good risk-management systems," she said in a speech to the Mutual Fund Directors Forum on September 9, 2011. "Derivatives are not 'bad,' but they are potent and at times full of surprises." The focus of the SEC going forward seems to be a desire to eliminate those surprises through greater transparency.
Obviously, these instruments were not under consideration when the SEC published the Investment Company Act of 1940, which set forth the rules regarding leverage in mutual funds. But the principles in that act are seen by many as having direct relevance to the current use of derivatives. One response to the Concept Release describes some provisions of the 1940 act as "almost prescient… as if they had been written with derivatives in mind." It argues that the guidelines of the 1940 Act should simply come into play today: "Funds which use derivatives, including ETFs, should be clearly identified and separated from those which do not. Those instruments which use or ARE derivatives should carry a warning like a pack of cigarettes. OTC derivatives should be distinguished, in this cautionary labeling, from traditional exchange-traded derivatives which are easily valued, such as put and call options on equity securities."
The SEC considered some of these concerns in a 1979 policy statement, which addressed the idea that fund directors weren't adequately considering "potential loss of flexibility when determining the extent to which the fund should engage in" certain leveraging techniques. At that point, the SEC put the responsibility for valuating exotic instruments onto the fund directors: "Directors should review their current valuation procedures, accounting systems, and systems of internal accounting control to determine whether any inadequacies exist with regard to the valuation and accounting treatment of such securities trading practices."
SEC chairman Arthur Levitt spoke more bluntly on the topic in 1995. "If directors don't take the time to understand how derivatives work, how a fund is using them, how clearly they are described to shareholders, and what the exposure of shareholders is," Levitt argued, "well, if the investment portfolio begins to explode, those directors are likely to get burned along with the fund and its shareholders." The SEC is now trying to tamp down those explosions.
