Complex alts keep regulators on toes

If the 2003 mutual fund scandals taught us anything, it’s that regulatory oversight sometimes can fall short and depends heavily on the cooperation of the asset management industry.

But the fund industry continues to grow and evolve. And even as internal oversight and cooperation with regulators have been stepped up over the past 10 years, so has the development of an increasingly complex category known as alternative investments.

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Driven partly by economic circumstances and partly by the adoption of more-sophisticated strategies, the number of alternative-class mutual funds has quadrupled to 399 over the past 10 years.

Total assets in those funds, as tracked by Morningstar Inc., are at nearly $120 billion, up from less than $15 billion in 2003.

Alternatives explode

“I do think the regulators are working feverishly to keep up, but the alternatives category is growing rapidly,” said Don Phillips, president of fund research at Morningstar.

“Some of those funds are doing things they didn’t do before, including greater use of high-potency tools,” he said. “They are using complex securities with complex names, and even if you could drill down, you might not fully understand what impact it all has on an overall portfolio.”

With the wide-scale influence of chief investment officers and independent board members at the fund companies, there is little doubt that efforts are being made to police the industry better, but some still worry that the influence of alternatives represents a challenge for which regulators are woefully unprepared.

“There is clearly a challenge for regulators to keep up with and understand what many of those strategies really are all about,” said Peter Mangan, president and chief executive of Shareholder Service Group Inc., which provides back-office support to financial advisers.

“It is a tough area for regulators to follow, because they often don’t find out there’s a problem until somebody has a problem and complains about it,” he said. “It’s the kind of thing that can be difficult to watch even if you’re familiar with it.”

Although the broad category of alternative mutual funds does include many straightforward long-short strategies, some use leverage, and esoteric and difficult-to-price strategies involving derivatives.

James Ball, president of Ball Financial Services Co., worries about alternative funds being misused inside client portfolios, which could pose some investor suitability challenges.

“For the majority of alternative funds, they are generally hedged and are likely to underperform, rather than create additional risk,” he said. “But when it comes to leveraged or derivative-based strategies, many of them are really designed for daily use, and not long-term holding.”

Whatever comfort might come from investing in alternatives wrapped inside a registered mutual fund could fade away under the pressure of certain market gyrations, Mr. Phillips said.

“Some of the oversight procedures set up for traditional mutual funds don’t always work in the alternatives world,” he said. “For instance, a fund might show some derivatives exposure along with 98% cash as collateral for the derivatives, but the real impact of those derivatives might add up to a 100% footprint in a portfolio.”

It ultimately boils down to advisers’ stepping up and embracing more responsibility for the oversight that once might have been entrusted to fund companies and regulators.

“As the financial world has gotten exponentially more complex, there has been much more of a need for advisers to be more aware of what is happening in the industry,” said Susan Ferris Wyderko, president and chief executive of the Mutual Fund Directors Forum.