In the wake of one of the worst financial market meltdowns in history, the Securities and Exchange Commission (SEC) is investigating the use of derivatives in mutual and exchange traded funds (ETFs). But some industry experts are afraid that the SEC may go too far and outlaw the use of derivatives all together, to the detriment of investors.
In 1940, the Investment Company Act was crafted with the understanding that funds would invest in stocks, bonds and cash-type holdings, reports Suzanne McGee of The Wall Street Journal.
But with the invention of derivatives, which are securities linked to some underlying asset, funds have veered from a strict adherence to the ICA. Specifically, funds have used derivatives to effectively leverage their assets, gain exposure to certain kinds of investments and hedge against risk. The ICA bans the use of leverage in funds. [The Fate of Derivatives.]
Andrew Donahue, head of the investment-management division at the SEC, declined to expound on whether new policies would be put in place against the use of derivatives or when the SEC would actually make a decision. The SEC has already decided to no longer grant automatic approval to new leveraged ETFs that rely on derivatives. [Regulation of New Derivative-based ETFs.]
Donahue says it’s not a ban, but that the SEC wants to better understand how the funds use derivatives. To some fund providers, it feels like one, since they’ve seen planned launches effectively put on ice while the SEC probes the issue.
One industry executive, Robert Kurucza of Goodwin Procter LLP, says, “To regulate these products intelligently, you need to understand them and the way they are used. Otherwise, in the current environment there will be a tendency to overregulate what isn’t understood. That will stifle competition and eventually work to the detriment of the financial markets. We risk throwing the baby out with the bath water.”
On the other hand, Todd Rosenbluth of Standard & Poor’s Financial Services LLC, says the lack of transparency in derivatives and how funds are using them is something the SEC should address. He notes that even when funds fully disclose their investment strategies, investors may not understand them. For example, there are some cases where investors will lose money on oil or gas ETFs, even while the price of the commodity is going up.
For more stories on the banking industry, visit our financial category.
Sumin Kim contributed to this article.