Commodities funds under fire

Rule change means they'll have to register with the CFTC as well as the SEC

Apr 15, 2012 @ 12:01 am

By Jason Kephart

The CFTC is cracking down on mutual funds that invest heavily in oil, natural gas and other commodities — and it could lead to higher costs for investors.

The Commodity Futures Trading Commission said in February that it will put the kibosh on a rule exclusion that allows mutual funds that invest in commodities through futures contracts and other derivatives to bypass having to register with it as a commodities pool operator. Such funds — like all mutual funds — are overseen by the Securities and Exchange Commission.

The change to the so-called Rule 4.5 exclusion, which will take effect Jan. 1, also will affect managed-futures mutual funds.

In amending Rule 4.5, the CFTC said that it is going after a small number of “futures-only investment options” that it contends should have been under its regulation to begin with.

The CFTC is making the change in order to “assess the risk posed by such investment vehicles in the derivatives markets and the financial system generally,” the regulator's commissioner, Jill E. Sommers, said in a speech in February.

Dennis Holden, a spokesman for the CFTC, declined to comment further.

Predictably, the mutual fund industry is up in arms about the rule change.

Karrie McMillan, general counsel for the Investment Company Institute, last month characterized the CFTC's actions as a “regulatory land grab.”

“There's only one explanation for the Rule 4.5 amendments that makes sense to me,” she said at a gathering of mutual fund executives in Phoenix.

“The CFTC decided that the turmoil following Dodd-Frank created a perfect opening for a regulatory land grab. The result will either vastly expand the CFTC's jurisdiction — or drive mutual funds out of the markets for futures, options and swaps,” Ms. McMillan said.

“Either way, investors lose,” she said.

Ms. McMillan wasn't available to comment further last week.

About 50 mutual funds, holding $60 billion in assets, will be affected by the policy change, according to Morningstar Inc.

The change comes as broad- basket commodities funds and managed-futures funds are gaining popularity with investors, thanks mainly to the inflation protection offered by commodities and managed futures' noncorrelation to the stock markets. Over the 12-month period ended Feb. 29, broad-basket commodities funds and managed-futures funds experienced $6 billion and $3.3 billion in net inflows, respectively.


Fund companies resent the idea of having to register their funds with two regulators, the SEC and CFTC. Having to do so will increase the cost of compliance, which ultimately will get passed down to investors, without adding any additional protections, they claim.

“It's going to immediately impact the profitability of the funds,” said John McGuire, a partner in the investment management and securities industry practice at Morgan Lewis & Bockius LLP. “Over time, firms are going to try to get profitability back to where it was, and they're probably going to have to raise fees to do that.”

As it stands, board-basket commodities funds and managed-futures funds aren't exactly cheap.

The average expense ratio of broad-basket commodities funds, for example, is 1.32%, compared with 1.26% for the average large-cap U.S. stock fund, according to Morningstar. Managed-futures funds, meanwhile, come with an average expense ratio of 2.6%.

Opponents are also worried that the policy change could unintentionally affect a wide range of other funds. At this point, it is still unclear what the CFTC considers a commodities derivative and how much of a fund's assets would have to be invested in them to trigger CFTC registration.


Funds of funds that invest a portion of assets in commodities futures, for example, could be affected. So could mutual funds that use swaps on broad-based indexes such as the S&P 500.

“Who's going to have to register is the million-dollar question, and I don't think anybody knows for sure,” Mr. McGuire said.

The rule change also will require fund companies to bolster disclosures related to funds that invest in commodities and managed futures. The CFTC generally requires more disclosure than the SEC.

The CFTC, for example, requires commodities pool operators to disclose fees paid to brokers. The SEC doesn't.

The SEC also prohibits fund companies from touting the past performance of similar funds in prospectuses of new mutual funds. The CFTC, however, requires commodities pool operators to list the performance of similar products that they manage when registering a new fund.

The two regulatory bodies are now working to harmonize their disclosure requirements.

“The impact on funds required to register with both agencies will be based in large part on the harmonization of the CFTC's rules,” said Nicole Goodnow, a spokeswoman for Fidelity Investments. “We are in the process of assessing the rule proposal, and any comments we have will be made directly in response to the proposal.”

Fidelity manages the $9 billion Fidelity Series Commodity Strategy Fund (FCSSX), one of the largest funds likely to be affected by the amendment.

Advisers are of mixed opinion on whether increased regulation of the funds is necessary.

“I don't know that extra regulation is going to protect investors any more than the regulation we already have today,” said Rick Kahler, president of Kahler Financial Group Inc. “If anything, we need the right regulation, rather than trying to force two different regulators to mesh.”

Laurie Belew, a senior financial adviser at Fox Joss & Yankee LLC, said that more disclosure could be helpful, particularly with managed-futures funds, to which almost all of the firm's clients have some allocation.

But ultimately, it will depend on what the cost of the extra transparency is.

The firm's investment committee is researching how the rule changes may affect the funds, Ms. Belew said.


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