Mutual Fund Industry Opposing SEC Plan to Limit Derivative Bets

The mutual fund industry’s main trade group is opposing a proposed cap on derivatives use by its members, saying the limit would disproportionately hurt fixed-income investors.

Taxable-bond funds with almost $500 billion under management already exceed the primary limit that regulators plan to adopt for registered funds that invest in derivatives, according to the Investment Company Institute. The draft regulations, proposed by the U.S. Securities and Exchange Commission in December, require most funds to restrict their derivatives exposure to 150 percent of net assets.

“If they adopt these limits, they would be curtailing an investment strategy that is beneficial to fund investors,” David Blass, the ICI’s general counsel, said Wednesday in a telephone interview. “It’s an unanticipated consequence.”

The SEC is seeking to prevent funds from taking on excessive Leverage Leverage In financial trading, leverage is a loan supplied by a broker, which facilitates a trader in being able to control a relatively large amount of money with a significantly lesser initial investment. Leverage therefore allows traders to make a much greater return on investment compared to trading without any leverage. Traders seek to make a profit from movements in financial markets, such as stocks and currencies.Trading without any leverage would greatly diminish the potential rewards, so traders In financial trading, leverage is a loan supplied by a broker, which facilitates a trader in being able to control a relatively large amount of money with a significantly lesser initial investment. Leverage therefore allows traders to make a much greater return on investment compared to trading without any leverage. Traders seek to make a profit from movements in financial markets, such as stocks and currencies.Trading without any leverage would greatly diminish the potential rewards, so traders Read this Term through derivative contracts such as currency forwards, credit-default Swaps Swaps Swaps can be defined as a derivate contact composed of two parties that exchange to cash flow between two separate financial instruments.They are generally divided into two categories. This includes contingent claims (options) and forward claims, where forward contracts, swaps, and exchange-traded funds (ETFs) are exchanged. Commodity price, equity price, interest rate, and foreign exchange rate are common variables used as one of the cash flows in swaps upon initiation. Different Types of Swaps Swaps can be defined as a derivate contact composed of two parties that exchange to cash flow between two separate financial instruments.They are generally divided into two categories. This includes contingent claims (options) and forward claims, where forward contracts, swaps, and exchange-traded funds (ETFs) are exchanged. Commodity price, equity price, interest rate, and foreign exchange rate are common variables used as one of the cash flows in swaps upon initiation. Different Types of Swaps Read this Term and interest-rate futures. The ICI says the restrictions would inadvertently preclude funds from using the financial contracts as a more efficient way of betting on markets for stocks, bonds, commodities and currencies.

The SEC is attempting to modernize U.S. securities laws to account for the growing use of derivatives by registered investment companies, a $17 trillion industry comprising closed-end and exchange-traded funds as well as traditional mutual funds. The ICI plans to lay out its views by filing a letter with the agency on March 28, the deadline for public comments on the proposal, Blass said.

‘Flawed Methodology’

While the trade group supports some provisions of the draft regulations, it disagrees with the SEC’s plan to create overall limits on the amount of derivatives a fund portfolio can hold. Until now, there has been no formal cap; the agency simply required funds to ensure that they held enough stocks, bonds and other liquid assets that could be sold to meet derivative obligations.

Under the December rule proposal, a registered fund’s total exposure to derivatives and other forms of leverage, such as borrowed money, would be capped at 150 percent of net assets. The SEC plan envisions a higher threshold, generally 300 percent of net assets, for funds that are deemed to be using derivatives to decrease, rather than increase, risk.

The ceilings would be based this on the notional, or face, value of the derivative contracts. That overstates the amount of economic exposure created by some derivatives, according to the ICI.

The proposed limits “are based on a flawed methodology,” Blass said. Notional value “doesn’t adequately reflect economic risk or leverage, so it is a very harmful test.”

Replicating Securities

A fund that enters into a $1 billion interest-rate swap might only stand to gain or lose several million dollars. By contrast, one that writes an insurance-like derivative contract known as a credit-default swap on $1 billion of corporate debt faces the prospect of ponying up the entire notional value.

Because individual bonds are often hard to locate and even harder to trade without affecting prices, many taxable-bond funds seek to replicate the securities in the far larger markets for derivatives such as futures, options and swaps. That makes them more likely to run up against the SEC’s proposed limit, Blass said.

According to an ICI study covering 80 percent of the industry excluding money-market funds, taxable-bond funds with about $480 billion of net assets exceeded the SEC’s proposed cap at the end of last year. That’s equal to 16 percent of the $3 trillion in net assets held in taxable-bond ETFs and mutual and closed-end funds as of Dec. 31, according to research firm Morningstar Inc.

To contact the reporter on this story: Miles Weiss in Washington at mweiss@bloomberg.net. To contact the editors responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net, Josh Friedman

By: Miles Weiss

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