Reports Warn of Unintended Consequences of Proposed SEC Rule

March 29, 2016

Two new reports conclude that a proposed Securities and Exchange Commission (“SEC”) rule that seeks to standardize the regulation of derivatives in mutual funds relies on an insufficient measure of risk exposure and, if enacted as written, would leave mutual fund investors with the choice of less-diversified strategies with a lower expected risk/return tradeoff than they currently enjoy access to.

The statute — Rule 18f-4, a proposed exemptive rule under the Investment Company Act of 1940 — aims to reduce leverage risks perceived to be associated with derivatives. The SEC has acknowledged that the rule also would require the managers of certain types of liquid-alternative mutual funds to significantly change investment strategies or deregister under the 1940 Act and operate as private funds or commodity pools.

In one new paper, “Proposed Rule 18f-4 on the Use of Derivative Instruments by Registered Investment Companies: Data and Economic Analysis,”  James A. Overdahl, Ph.D., of the Delta Strategy Group contends that the proposed rule is an “inefficient and ineffective” way for the SEC to limit the use of leverage by mutual funds.

Overdahl, a former Chief Economist at the SEC, contends that the proposed rule’s “gross notional value” limit is a poor measurement of risk exposure and may unintentionally drive investors to riskier investments. As currently written, he adds, the rule could harm investors by placing excessive constraints on funds that currently use derivatives in a risk-controlled manner.

In another report, “Liquid Alternative Mutual Funds: An Asset Class that Expands Opportunities for Diversification,” Professor Craig M. Lewis, Ph.D., of Vanderbilt University writes that funds that employ derivatives “enable investors to construct diversified portfolios that either reduce the level of risk for a given level of return, or increase returns at the same level of risk, or both.”

Lewis adds that such funds “have enabled ordinary investors to access an important, diversified asset class that had previously available only to high net worth individuals and institutional investors.” He concludes that the empirical evidence suggests that funds using derivatives “do not subject investors to undue risk.”

Both authors received financial support for their work from the Coalition for Responsible Portfolio Management. The Coalition represents leading investment firms that seek to engage and educate policymakers and public audiences about the value of alternative liquid mutual funds, especially for ordinary investors preparing for a secure retirement. The Coalition aims to provide research on the growing use of alternative liquid mutual funds to educate and to advocate for policy measures that ensure access to these funds for all investors for diversification and retirement security.

Coalition members include Affiliated Managers Group, Inc. (AMG), AQR Capital Management, First Quadrant, John Hancock and the Moneta Group.

Arbitrage funds are distributed by ALPS Distributors, Inc.

  • The information contained herein is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.