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SEC proposals target mutual funds

New advice and investment firm rules would change the fund universe

May 8, 2016 @ 12:01 am

By Andrew Rogers

The regulatory environment for financial services is ever-changing, and periods following market disruptions create opportunities for regulators to propose new rules to prevent further failures. For example, the financial crisis of 2008 resulted in Dodd-Frank, which set forth new rules centered on capitalization requirements to prevent similar events. Regulators are now proposing rules for advisers and investment companies that will change the mutual fund universe.

The mutual fund industry has created an alphabet of share classes based on broker commissions and platform fees. Proposed fiduciary standards from the SEC requiring representatives to select investments in the best interests of investors (along the lines of the Labor Department's recently released fiduciary rule for retirement advice) may limit the ability to sell classes with higher expenses and load commissions. This may result in the collapse of many classes of mutual funds.

The SEC also is proposing rules related to risk and risk management, particularly the use of derivatives. Regulators are very concerned about liquidity and leverage, since many of the Dodd-Frank provisions resulted in fewer market-makers and less liquidity in the marketplace. Many credit portfolio managers have said there is less liquidity in the marketplace than at any time in their careers, and as a result, investors and advisers appear to be seeking higher returns in the current low-interest-rate environment, investing in bonds that have higher risk and lower liquidity.

The financial crisis resulted in the creation of liquid-alternative funds that use derivatives for various reasons — and these funds, which enable investors to cushion their portfolios against market volatility, may be most affected. If regulations surrounding the use of derivatives become a reality, liquid-alternative managers may have to prove to regulators that their derivative exposure doesn't lead to excessive leverage.

The proposed rules include the requirement for fund managers that invest in derivatives to establish a chief risk officer position. The CRO would report directly to the board of an investment company in a fashion similar to chief compliance officers and corporate boards. The CRO would be in charge of creating a program to manage risk and develop a reporting infrastructure that would be reviewed by the board and eventually regulators — and the CRO would be responsible for making sure derivative exposure is kept in check.

The above proposed regulations may raise the barriers of entry to the mutual fund industry even higher because they would cause fund managers to incur substantial expense at the exact time the popularity of passive investments is creating demand for lower mutual fund fees.

Mutual fund managers provide an important service to the investment community. In order to keep useful strategies like liquid alts available to investors, regulators should find the right balance between managing risk and not constraining mutual fund managers too tightly.

Andrew Rogers is CEO of the Gemini Cos.

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