The hedge fund industry wants parity with mutual funds in its ability to buy exchange traded funds under a Securities and Exchange Commission proposal to streamline ETF regulation.
Mutual funds and hedge funds are limited under the Investment Company Act of 1940 to ownership stakes of no more than 3% of the outstanding voting shares of other investment companies, including ETFs.
In the SEC's proposal, which would simplify the process by which ETFs could gain regulatory approval, the agency would permit mutual funds to invest in ETFs to a greater extent than currently allowed.
Giving hedge funds the same permission to buy more than a 3% stake in ETFs "would enhance the ability of private funds to meet their investment objectives, enhance market transparency, and increase liquidity and trading of ETFs, among other benefits," the Managed Funds Association of Washington wrote in a May 19 comment letter to the SEC on the proposal. Hedge funds are often referred to as private funds.
The limitation was imposed by Congress due to abuses from "pyramiding," in which funds could gain control of larger funds and enrich themselves at the expense of shareholders in the acquired fund, as well as concerns about the potential for excessive fees that could result from "layering" of fees in multiple funds.
Despite the historical fears of abuses, "now it's come to light that there are benefits to funds of funds," or funds that invest in other funds, said Jennifer Han, legal counsel for the MFA. "In certain instances, you can have a fund of funds and avoid the abusive situations which Congress meant to avoid," she said.
"There's no policy rationale for distinguishing hedge funds from other institutional investors," Ms. Han said. "Hedge funds use ETFs like other institutional traders. They use it for hedging purposes and risk management, and also to equitize cash balances."
The conditions the SEC has proposed for preventing abuses are "equally applicable to private funds as they are to mutual funds," Ms. Han said. "There's no reason not to provide the exemption" to hedge funds, she said.
Comments filed were favorable to the overall ETF proposal, and several commenters also asked that hedge funds be included in the ETF ownership proposal.
ETFs "are an attractive investment vehicle for many institutional investors, including registered funds and hedge funds," said Daniel Schloendorn, a partner with New York law firm Willkie Farr & Gallagher LLP. He drafted a comment letter filed with the SEC on behalf of the New York City Bar Private Investment Funds Committee, which asked that hedge funds be allowed to make larger investments in ETFs.
"So long as hedge funds are able to satisfy the same conditions that the SEC has laid out in this rule proposal, they ought to be able to invest in ETFs beyond the 3% limit, to the same extent registered funds are," Mr. Schloendorn said.
Under the conditions stipulated in the SEC proposal, mutual funds could not control an ETF, the acquired ETF may not be a fund of funds, and fees charged by the acquiring fund could not violate the sales charge rule of the New York- and Washington-based Financial Industry Regulatory Authority Inc. to prevent duplicative fees.
In addition, a fund acquiring a stake in an ETF could not redeem the shares directly from the ETF but would be free to sell the shares in the secondary market.
The Investment Company Institute in Washington also called for the SEC to allow funds of funds to purchase more than 3% of an ETF.
"We support these proposals because they allow affiliated funds of funds to enhance the diversification and investment opportunities they can provide to their shareholders," said ICI spokesman Ed Giltenan.
"There are no grounds for distinguishing between an acquiring fund that is primarily an affiliated fund of funds and another type of acquiring fund," the ICI wrote in its comment letter, signed by ICI general counsel Karrie McMillan.
State Street Global Advisors of Boston also called for lifting the prohibition on hedge fund acquisitions of larger stakes in ETFs.
"Private funds should be treated comparably to other investment companies for purposes of the rule," James Ross, senior managing director of SSgA, wrote in his comment letter.
The conditions the SEC has proposed for mutual funds "are equally applicable to private funds," the SSgA letter stated.
Referring to the original concern of the 1940 Congress, that funds purchasing funds could lead to overly complex structures, SSgA argued: "Private funds frequently engage in complex, structured transactions, compared to which an investment in an ETF in excess of the 3% limit seems fairly simple."
E-mail Sara Hansard at [email protected].
