A rule proposed by the Securities and Exchange Commission to address the use of derivatives by mutual funds, exchange-traded funds and business development companies will, if enacted, substantially alter the universe of alternative strategy funds available to investors.
The proposed rule 18f-4, released by the SEC Dec. 11, seeks to limit the use of leverage and derivatives in the funds of those registered investment companies. The exposure-based portfolio limit would place a 150% cap on derivatives exposure used to increase market risk, while a risk-based portfolio limit enforces a 300% limit on derivatives used to reduce market risk. The rule, as written, seems to equate the greater use of leverage and derivatives with greater risk, a conclusion not always supported by the evidence.
The SEC is responding in part to the rapid growth in the number of liquid alternative funds, a broad category that includes several different types of “alternative” strategies under mutual fund, ETF and BDC structures. SEC research shows that liquid alternative funds are now 3% of total registered fund assets under management after growing at an annual rate of 22% between 2010 and 2014, excluding the commodity sector that has been challenged by outflows.
While liquid alternative funds, to date, have received the majority of their flows from individual investors, this is still an important debate for institutional investors.
To the extent that institutional investors are invested in private partnership hedge funds, it is in the investor's best interest for the hedge fund turned liquid alternatives manager to have revenue from these new offerings to enhance their infrastructure and perhaps offer fee breaks to their investors. In Europe, UCITS — undertakings for the collective investment in transferable securities, funds that are regulated at the European Union level — have an increasingly institutional investor base, as new regulations are pushing pension funds toward more liquid and transparent products. In addition, defined contribution plan sponsors might also wish to consider liquid alternative funds for their participants who do not have access to private placement funds and wish to diversify their portfolios beyond stocks and bonds.
These proposed rules seem to function as a blunt instrument, a hammer instead of a scalpel. If they are enacted in a manner that restricts the ability of many liquid alternative managers to operate in a registered fund format, then large swaths of the investing public will lose an important tool that has allowed them to manage risk in a manner similar to that available to accredited investors and qualified purchasers. Should the SEC regulations negatively affect the ability of managers to offer alternative strategies in public vehicles, these attractive options will disappear as the size and number of public vehicles declines.
Retail investors and their financial advisers have contributed to the substantial asset inflows in liquid alternative funds, driven by a desire to reduce portfolio risk by investing in strategies not available through traditional mutual funds. Non-traditional bond funds appeal to investors who would like to participate in credit markets while reducing the risk of rising interest rates. Allocations to managed futures funds give investors access to trading strategies that have historically provided investors diversification benefits during times of financial distress and significant drawdowns in equity markets.
While most long-only equity mutual funds have positions that are within the limits proposed by the SEC, many alternatives funds have positions in excess of these limits. Using a sample of approximately 10% of registered funds, the SEC estimates 99% of traditional long-only equity and fixed-income mutual funds have derivatives exposure below 150% while 27% of alternative strategy funds have exposures above 150%, including 11% above 300%. Managed futures and non-traditional bond funds are most likely to have exposures exceeding these limits, with derivatives exposures averaging approximately 450% and 150% of net asset value, respectively.
But these exposures don't always equate to higher levels of risk.
Take a look at the returns of a traditional 60/40 stock/bond portfolio when 10% of the stock allocation is moved to funds tracked by the Morningstar Diversified Futures index, and 10% of the bond allocation is shifted into funds tracked by the Morningstar Non-Traditional Bond index. Examining the period of calendar years 2006 through 2015, the traditional 60/40 portfolio had an average annual return of 3.85% with a standard deviation of returns of 9.89%. With a 20% allocation to liquid alternatives, returns are relatively unchanged at 3.76%, with dramatically lower risk of 8.35%. In 2008 and 2009, when the stock and bond portfolio lost more than 35% of its value, the portfolio with 20% invested in liquid alternatives lost less than 30%. This can be attributed to the lower standard deviation of managed futures, 8.4% relative to that of the S&P 500 index at 15.3%, as well as the negative correlation of managed futures with stocks and bonds. With a correlation of just 0.18 to the Barclays Aggregate Bond index, non-traditional bonds add another layer of diversification.
Clearly, elevated levels of leverage and derivatives usage alone cannot be used to directly measure or predict the volatility of fund returns. The tests of leverage and derivatives exposure should be sophisticated enough to consider the entire risk picture of a fund and not focus on simple levels of gross or net exposures.
Rather than seeking broad limits on the size of derivatives exposures, the SEC should evaluate the risk of a fund holistically and provide for enhanced disclosure of derivatives holdings to better inform investors of their fund choices.
The new monthly reporting form, N-PORT, included as part of the derivatives limitations proposal, seeks to enhance disclosure by requiring funds with more than 50% derivatives exposure to produce monthly statistics detailing notional exposures as well as option risk factors such as delta, gamma, vega. I would argue instead for a greater emphasis on education and disclosure as well as strongly urge the regulators and the industry to develop a more robust classification system for the funds that reside under the liquid alternatives banner.
If we better equip investors to make educated choices, we might be able to arrive at outcomes that benefit both the fund industry and the investor community. n
