Alternative Funds: Cause For Concern?

by: Zacks Funds

This is the platinum jubilee year for the 75-year old "legal framework" Investment Company Act of 1940. While this framework for mutual funds and other funds in the U.S. along with the Securities and Exchange Commission have continued to be the backbone of U.S. financial regulation, there are "some cracks" starting to appear. At an event at the Brookings Institution in Washington on mutual funds over the next 75 years, SEC commissioner Kara Stein said: "I am concerned that we are starting to see some cracks in the foundation".

The primary concerns were related to mutual funds and exchange-traded funds that make use of significant portion of leverage, invest in illiquid securities and execute strategies like hedge funds. Kara Stein said that these mutual funds and ETFs are using complex and risky strategies to bet on illiquid assets "often operate in a gray area of mutual fund regulation." These so-called alternative funds have soared in popularity. Morningstar noted that the market increased to $311 billion in assets under management at the end of 2014 from $46 billion in 2008.

Alternative Funds under Scanner

The alternative mutual funds, at the center of this issue, are "hard to define" and Stein says that they "mean different things to different people". However, they use an investment strategy in a nontraditional asset class and may invest in illiquid assets. They "also frequently seem to rely on derivatives for their investment returns," said Stein.

The alternative mutual funds duplicate hedge funds to outperform markets and attract investors. However in doing so, they may not adhere to Investment Company Act of 1940's liquidity and leverage rules.

Funds Flout Investment Company Act of 1940 Framework

Despite the existing rules, Stein says that many funds are avoiding some restrictions and in certain cases also relying on exemptions granted by SEC staff.

Here we would like to highlight specific requirements of the Investment Company Act of 1940 (as explained by Investopedia):

  • Limit their investment strategies, such as the use of leverage.
  • Maintain a certain percentage of their assets in cash for investors who might wish to sell.
  • Disclose their structure, financial condition, investment policies and objectives to investors.

Stein said: "We all need to be asking questions about the development of these funds and what they mean to the retail investor. Do investors understand these products? Are these funds adhering to the foundational principles of the Investment Company Act?"

"They may be less liquid, employ more leverage, and invest in exotic and complex instruments… At a minimum, this raises the question of retail investor confusion," Stein added.

Ms. Stein raised concerns that so-called alternative mutual funds appeal to investors as a way to outperform the market by mimicking hedge funds while not adhering to the Investment Company Act of 1940 rules governing liquidity and leverage.

Illiquid Bank Loans

Separately, the "new, complicated registered funds" that invest in bank loans are also a cause of concern. Many of the underlying loans in these funds may take more than a month to settle. "If it takes over a month to settle, it is reasonable to wonder how the fund could possibly meet the seven-day redemption requirement in the Investment Company Act in times of market stress," said Stein.

What is concerning is that these bank loan funds' holdings may be entirely of illiquid bank loans. This completely ignores the SEC's 15% threshold. The SEC guidance states mutual funds may hold up to 15% of fund's assets in illiquid securities.

"Some may also invest in collateralized loan obligations (CLOs). How is this happening?" Stein questioned.

Regulators Get Busy

While the rules require funds to disclose enough information for investors, Stein said that there has been a shift that "places the onus on the retail investor to figure out whether a fund is right for him or her." Stein added: "The liquidity of registered funds is one area where it seems that regulation has drifted into "buyer beware."

The comments juxtapose with the SEC and other regulators' recent close scrutiny of the asset management sector. They are even questioning if certain products are risky affairs now.

Recently, the Securities and Exchange Commission proposed a rule recently that mutual fund companies must disclose how vulnerable their bond portfolios are to rate hikes. The plan requires mutual funds to publish their exposure to derivatives, repurchase agreements, and securities lending. The reports will also contain details about position-level holdings, counterparty exposures, derivatives contracts terms and the risks associated with rate hike.

Talking of bond funds, there is a growing concern that a massive exit from bonds may freeze the markets as the number of sellers may not match the number of buyers. Redemption of bonds would increase the sell off and then fund managers will have to sell the less liquid assets to match the investors' cash demands. However if a mutual fund or an ETF holds illiquid bonds, the price swings will be rapid and would create a vicious cycle as price drops will again intensify selling pressure.

As for risks, Financial Stability Board's (FSB) contemplation to designate the biggest asset managers as "systemically important" has not gone down well with top fund managers. Mark Carney, chair of the FSB, said the risk on investor runs on "funds that offer on-demand redemptions but invest in less liquid assets."

Alternative Mutual Funds

These mutual funds, as said earlier, make use of leverage, short selling and hedging actions among others. If the concerns are true, investors may want to avoid the following mutual funds that have similar strategies.

American Beacon Flexible Bond A (MUTF:AFXAX) invests in fixed-income instruments that have varying maturities and derivative instruments providing exposure to fixed income instruments. While a meager 0.54% of assets are invested in stocks and 8.16% in cash, AFXAX has 300.8% of assets allocated to bonds.

AFXAX currently carries a Zacks Mutual Fund Rank #5 (Strong Sell).

Toews Hedged Core Frontier Fund (MUTF:THEMX) invests in ETFs, derivative instruments, fixed income securities, common stock and cash equivalents related to emerging market issuers outside the U.S. and even of U.S. issuers. THEMX has lost 7.2% and 7.5% year to date and over 1 year period. The 3 and 5 year annualized returns are -3.5% and -7.9%.

THEMX currently carries a Zacks Mutual Fund Rank #4 (Sell).

However, investors may instead buy Balanced mutual funds as they enjoy the flexibility of varying the proportion of equity and fixed income investments in response to market conditions. PIMCO StocksPLUS Fund D (MUTF:PSPDX) and Putnam Dynamic Asset Allocation Balanced Fund (MUTF:PABYX), both carrying Zacks Mutual Fund Rank #1 (Strong Buy), should be good additions to the portfolio.

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