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 through derivative contracts such as currency forwards, credit-default swaps 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.
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.
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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.”
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.
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