By Scott Burns
The SEC's March 25 decision to defer the review of any new exemptive relief filings that made heavy use of derivatives sent ripples through the fund industry. Particularly named were active and leveraged strategies. The SEC stated that this was part and parcel of an ongoing review of the use of derivatives in mutual funds, exchange-traded funds, and closed-end funds (the collective known as " '40 act funds" for the Investment Company Act of 1940 that governs these securities.)
The furor in the fund industry over this announcement grew so loud that the usually reserved SEC needed to make clarifying statements to try to calm things down. Unfortunately, as far as I can tell, the clarification only reiterated what the announcement said, so there are still plenty of unanswered questions.
A feature by Ignites (registration required) provided the excerpt of explanation from SEC spokespersons:
"(Elizabeth) Osterman also makes clear that the exemptive application process for actively managed ETF products that propose using significant amounts of derivatives 'can move forward' as long as the funds agree to restrict the use of certain derivatives. Specifically, the SEC is willing to proceed as long as actively managed, fully transparent ETFs represent that they will not invest in futures, swaps, and options, according to an agency spokesman, John Heine."
What does this mean? You can use derivatives, as long as you don't use derivatives? The only thing missing from the listed types of derivatives are forwards and swaptions--and I'm not really sure those were meant to be left off the list. Now, this could be a case of combining two different quotes from two people, but the result is clearly in conflict, and the confusion is mounting not decreasing.
Still, the SEC's decision to review the use of derivatives in terms of how leverage has been employed and disclosed and how the underlying collateral and counterparty risks have been reported couldn't be more on target. Given recent problems in the financial industry, bringing transparency to these issues is of the utmost importance. That is true regardless of whether or not the fund in question is a mutual fund, ETF, or closed-end fund. It is becoming nearly impossible for an investor to understand the notional exposure and risks associated with some of the largest mutual funds and most heavily traded ETFs, and that cannot stand.
While on target with the review of these crucial issues, there are some unintended consequences to this scattershot decision. There are several areas in the ETF space that would benefit greatly from the marriage of active management and derivatives.
Active Commodity ETFs
First up is the area that is most in need of active management involving derivative strategies. There is a real problem right now with many of the passive commodity futures tracking strategies regarding their inability to move away from adverse changes in the futures curve. This is the dreaded "Contango Problem" that has plagued popular funds such as United States Oil (NYSEARCA:USO). It is obvious that investors are looking for an ETF that will give them exposure to the price movements of commodities but are currently stuck with a slew of imperfect passive offerings that are getting killed by contango. An active manager would presumably be able to mitigate this problem by being able to purchase the most favorable part of the yield curve, while avoiding the traps of passive strategies.
This sorely needed innovation might be held up by the SEC's actions. Why is "might" still in the equation? Well, commodity futures-tracking ETFs are generally set up as limited partnerships and are governed by the Securities Act of 1933. On one hand, the SEC announcement clearly states that this deferral is targeted at '40 act funds. But other comments have mentioned the review of derivative usage "in all funds." So, it is hard to say at this time whether or not the commodity products are part of this broader review.
Active Fixed-Income ETFs
Over the past decade, fixed-income managers have become big users of derivatives to manage risk and gain exposures that are more liquid than they could achieve with individual bond positions. I believe that most of these products are being properly utilized. Probably the most common use of derivatives these days in an active manager's portfolio is to help them shorten up the duration of their holdings. Given the current interest-rate environment, this is generally considered a solid risk-management strategy.
There have been a few notorious cases of active managers using these products to provide leverage for their returns unbeknown to their investors. Again, this is a matter of how these positions are reported and how funds disclose their notional exposure and leverage risk. Improper usage can be detected with better disclosure.
Alternative Strategy ETFs
In this case we are talking about the hedge fund-like strategies that have been popping up in '40 act forms, especially in ETFs. We are hugely supportive of the convergence of hedge fund strategies to regulated and transparent investment vehicles. The ETF industry continues to demonstrate that there is no reason for investors to pay "two and twenty" fees to hedge funds so that they can take on hidden leverage and invest in illiquid assets. You can get those noncorrelated return strategies for less than 100 basis points in an ETF.
Whether active or passive, many of these strategies employ derivatives that are used to offset risk and actually hedge returns whether long or short. The leverage that is inherent in most derivatives allows these strategies to use smaller amounts of capital and keep costs low for investors.
The Real Target
The bull's-eye issue that the SEC is really getting after is leverage--not necessarily derivatives. If the financial crisis taught us anything it is that leverage should be unmasked: The notional exposure should be detailed and the parties involved should be transparent.
Although this action will certainly provide the SEC with time to review the use of derivatives, we would advise it that derivatives in these strategies should be looked at in terms of the aggregate leverage of the portfolio. An alternative strategy with offsetting longs and shorts is not leveraged in total, and a commodity manager picking and choosing her way along the futures curve is not employing leverage.
We need to be careful that the valiant efforts to root out the managers who abuse derivatives do not keep investors from having needed access to suitable strategies that employ these tools.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.