The SEC publishes on Aug 31 a rather a broad review of the use of derivatives by funds. The review is not entirely new is it is again a sequel to an earlier release by SEC in March 2010. Just a recap from the March release, the paper covers mutual funds, exchange-traded funds and investment companies defined under the Investment Company Act. The March paper quite ambitiously covers market practices, pricings, portfolio concentration and even corporate monitoring relating to the use of derivatives.
The paper this time concentrates more about the actual maneuvering of derivatives as an investment leveraging tool in funds. It covers five major aspects. The first attempts to measure the amount of leverage which has been utilized by a fund. The second one looks to measure the degree of investment diversification of any fund and the use of derivatives in it. The third concerns the difference/similarities between investing in a broker-dealer’s stock or bonds and derivatives issued by the broker-dealer. The last two concern portfolio exposure to derivatives and how these derivative instruments should be valuated. In short we can observe how this particular piece of consultation paper looks to streamline the valuation of derivatives, in terms of their make-up percentage in individual companies and the market as a whole. Should all the measures suggested by the SEC see the light of day their belief is that the market will become less unpredictable for retail investors.
But these measures may entail additional compliance cost for fund managers. The term “derivatives” on the other hand is also a far-stretching term. For some funds in particular, derivatives tend to comprise most and all of their investments. It is uncertain at this point the extent which fund operations could be affected, should this piece of suggestion become realized. In the backdrop of a stubborn economic downturn and witchhunting mood shared by regulators worldwide (in search of the culprit for the current stagnation), fund managers may consider thinking ahead to buff up their compliance and monitoring procedures.