|"Directors Could See Guidance From Controversial SEC Derivatives Review"
April 6, 2010
The SEC’s decision to review fund derivative use and defer exemptive applications for some actively managed exchange-traded funds (ETFs) has prompted concerns that funds may have to rethink investment strategies, but also could result in more guidelines for directors when it comes to oversight functions.
Andrew “Buddy” Donohue, director of the SEC’s Division of Investment Management, says the commission’s focus on board oversight is not intended as a criticism of directors, but as a way to eventually carve out some guidance on what their responsibilities should be.
“I don’t expect the board to be down in the trenches on the use of derivatives,” he says.
“On the other hand, I do think they should be talking to management, make sure… they have the necessary expertise, not just in portfolio management but in legal operations, in their systems, in their pricing, in their ability to deal effectively throughout the entire chain, that they have the necessary confidence to deal with them there and they can articulate when and how they’re going to use derivatives and how it benefits investors.”
The commission has said it is evaluating the use of derivatives by mutual funds, ETFs and other investment companies to determine if additional protections are necessary, particularly when it comes to leveraged or inverse ETFs. That review includes a look at whether directors are providing appropriate oversight, as well as an examination of current market practices, existing rules, prospectus disclosures and reporting requirements.
During the review, it is deferring consideration of applications for exemptive requests that would allow actively managed ETFs to make major investments in derivatives the SEC deems risky. The deferral applies to pending and new requests, but does not impact existing ETFs and other fund applications. The SEC also has said that it will consider applications from actively managed, fully transparent ETFs not investing in futures, swaps and options.
Mutual funds have increasingly become investors in ETFs — baskets of securities that seek to track a benchmark but trade intraday and can also be leveraged and sold short. And those that offer leverage or are meant to perform inversely to the index or benchmark they track have become more popular.
They are admired for their growth potential and have seen record sales. But leveraged and inverse ETFs have become the focus of the Financial Industry Regulatory Authority, which issued a notice to brokers warning that the products, which reset daily, may not be suitable for retail investors who plan to hold them for longer than one trading session.
The SEC’s announcement is seen as a reaction to widespread blame directed at certain exotic derivatives for at least in part causing the financial meltdown. Donohue says that the commission is acting on concerns it has had about derivatives long before the financial crisis.
The SEC has emphasized that its plan is not to deny, but to defer the application process. But the news has still elicited criticism from the industry that such a move could hamper innovation for funds that rely on actively managed ETFs, or even create a monopoly among those who have already secured their exemptive orders, putting other funds at a significant disadvantage.
Michael Mabry, a partner with Stradley Ronon Stevens & Young, says the funds that have already been granted those orders maintain an advantage until the SEC concludes its study.
“In terms of other funds that might want to invest in these kind of ETFs, it means that the selection of ETF complexes that are offering these kind of ETFs is going to be limited, extremely narrow, for the indefinite future,” he says.
“Those fund groups, lucky for them, will not be having any competitors entering the market any time in the near future…. To the extent you think that the reason for this derivatives study is because of the sort of volatile behavior of leveraged and inverse ETFs over a year ago, the ironic thing about this is that those very same ETFs have now been granted their virtual monopoly.”
One of those major ETF managers, Direxion Funds, says a monopoly is created in theory, but not in practice.
Andy O’Rourke, senior vice president of Direxion, says that while he agrees that the development seems like an advantage for players like Direxion, it’s not likely to have any impact on its competitive edge, as a lot of product companies don’t have interest in seeking such relief now anyway.
“I would say I don’t believe there are too many other firms out there that were implementing plans to enter the space,” he says. “We didn’t celebrate when we heard this news by any means.”
While Direxion already has an exemptive order, it says any further product innovation will be stifled, pointing to another initiative he says is “dead in the water.”
The SEC has issued about 86 such orders over the last 18 years, says Elizabeth Osterman, an associate director with the SEC's Division of Investment Management.
The SEC says it recognizes that those who already have exemptive relief have a market advantage, but that it was still necessary for the commission to take a step back and look at the financial instruments, which have become increasingly complex in ways that shareholders don’t fully understand. “That’s always true in the exemptive area, it’s why we ultimately like to move from the exemptive to a rule,” Donohue says.
O’Rourke says that he commends the SEC for taking on the review, although he fears the commission may have bitten off too large a chunk by naming derivatives in general, and not singling out the less transparent, more complex ones.
Further compounding industry concerns is the absence of any end date for the review announced by the SEC. While Donohue says the review will not take years, he did not offer any more specific timeline, saying only that the review is being done with a degree of urgency.
Bud Haslett, head of risk management, derivatives and alternative investments at the Chartered Financial Analyst (CFA) Institute, believes the deferral is simply signifying that the SEC wants to conduct its review without any additional funds trying to push through applications in the process.
“They’re just saying that any previously listed fund that uses derivatives can continue to do so, but we’re going to put a hold on approving any new ones until we decide how we’re going to handle things,” he says.
Although he agrees the move may force some funds to rethink their plans, Haslett commends the SEC for reviewing the use of derivatives, which he says can be useful when used properly and dangerous when used improperly.
Leverage will undoubtedly be a key to its review, he says, as will the differences between over-the-counter and exchange-traded derivatives.
“I know some folks who are involved with the over-the-counter derivatives that have contracts that have dozens of pages, if not over 100 pages, of terms and contracts,” he says. “It’s just mind-numbing how complicated… they can be, these customized contracts.”
Congress and regulators are considering a number of proposals, including one for the centralized clearing of contracts.
As far as fund board oversight is concerned, Haslett believes it’s important for directors to ensure they have a strong risk manager who can monitor the traders and portfolio managers for excessive risks.
“If you look at the investment positions just from a snapshot perspective, they can look like there’s not a lot of risk. But with movement, there’s implied risk. And so a director does not need to know what that implied risk is — what they need to know is that there is that risk out there, and that we have someone in the firm, a risk manager, who understands that,” he says.
“Their role is to make sure that the company is set up so that the appropriate people, being the risk managers, have the authority to prevent positions that could potentially be disastrous for the firm.”
He says problems were caused by risk managers not having the power they needed during the meltdown, and suggests that they could report directly to the board. “That way the risk manager doesn’t get watered down by going through his manager and then his manager, and being three or four levels removed from the directors.”
Jay Baris, a partner with Kramer Levin, says trustees should expect some principles-based guidance from the review.
“One possibility is that the commission will regulate by disclosure, which means, ‘Tell us what you’re doing. We’re not going to tell you how to do it, but tell us what you’re doing,’” says Baris, who chairs the Task Force on Investment Company Use of Derivatives and Leverage of the American Bar Association.