WASHINGTON — The hedge fund industry wants parity with mutual funds in its ability to buy exchange-traded funds under a Securities and Exchange Commission proposal to streamline ETF regulation.
Mutual funds and hedge funds are limited under the Investment Company Act of 1940 to ownership stakes of no more than 3% of the outstanding voting shares of other investment companies, including ETFs.
In the SEC's proposal, which would simplify the process by which ETFs could gain regulatory approval, the agency would permit mutual funds to invest in ETFs to a greater extent than currently allowed.
Giving hedge funds the same permission to buy more than a 3% stake in ETFs “would enhance the ability of private funds to meet their investment objectives, enhance market transparency and increase liquidity and trading of ETFs, among other benefits,” the Managed Funds Association of Washington wrote in a May 19 comment letter to the SEC on the proposal. Hedge funds are often referred to as private funds.
The limitation was imposed by Congress because of abuses from “pyramiding,” in which funds could gain control of larger funds and enrich themselves at the expense of shareholders in the acquired fund, as well as concerns about the potential for excessive fees that could result from “layering” of fees in multiple funds.
Despite the historical fears of abuses, “now it's come to light that there are benefits to funds of funds,” or funds that invest in other funds, said Jennifer Han, legal counsel for the MFA. “In certain instances, you can have a fund of funds and avoid the abusive situations which Congress meant to avoid,” she said.
“There's no policy rationale for distinguishing hedge funds from other institutional investors,” Ms. Han said. “Hedge funds use ETFs like other institutional traders. They use it for hedging purposes and risk management, and also to equitize cash balances.”
The conditions the SEC has proposed for preventing abuses are “equally applicable to private funds as they are to mutual funds,” Ms. Han said. “There's no reason not to provide the exemption” to hedge funds, she said.