On August 31, 2011 the US Securities and Exchange Commission (SEC) published a concept release titled, “Use of Derivatives by Mutual Funds and Other Investment Companies. As with most of their concept releases, they also requested public comments by individuals who invest in funds and managers of funds who use derivatives. Well Mr. SEC, here is one comment for you from none other than Jack Bogle, the founder of one of America’s largest mutual fund companies, Vanguard. In a recent Wall Street Journal article, Jason Zweig stated: “Mr. Bogle is irked by the proliferation of exchange-traded funds, many of which are narrowly focused”. I would say that Mr. Bogle is a little more than “irked” as he said to Mr. Zwieg, ETFs often “are just great big gambling, speculative instruments that have definitely destabilized the market.”
Today mutual funds, including ETFs, control over $13 Trillion for more than 40% of all U.S. households who own their shares. With that much money and so many investors I find it amazing that today, as it was when I first entered this business over thirty years ago, almost no mutual fund investor can tell me how much they are paying in commissions and fees, nor can they name any of the investments their fund has invested in on their behalf, let alone if the fund uses derivatives.
Of course, there is nothing illegal about the use of derivatives in a mutual fund portfolio, nor is there any requirement that fund investors know how much they are paying and where their money is invested. Knowing full well that most individuals would not pay much attention to details, the Investment Company Act of 1940 created safeguards for investors that include public disclosure of fees and investments within the fund. However, it is still up to the individual investor to find them. When was the last time you sat down and read the disclosure documents of your mutual fund?
One other thing the writers of the Investment Company Act of 1940 could not do: They could not foresee the increased use or the complexity of derivatives used by today’s investment company. A derivative, as described by the SEC, is “a type of financial instrument whose value is derived from another underlying product, include such things as futures, certain options, options on futures, and swaps”.
The real risk of these investments is that almost all derivatives include the use of borrowed funds. It’s these borrowed funds that causes the concern of the SEC, as it should. Mary Schapiro, The Chairman of the SEC, says in her comments concerning this release, “…a relatively small investment in a derivative instrument can expose a fund to a potentially substantial gain or loss – or outsized exposure to an individual counterparty.
The SEC in this release is proposing to limit the use of derivatives by funds. Their proposals include exposure limitations and cover rules requiring fund companies to set aside enough money to cover the liability they assume from their derivative activities. I am all for this even though there will be an increase in cost to fund investors.
Your mutual fund cost will increase to cover the initial set-up and the ongoing cost of a derivative exposure measurement system, plus the higher cost associated with the increased capital requirement needed to support a leveraged portfolio. Personally, I would like the SEC to go even further by completely eliminating the use of derivatives from funds that are sold to the public. After all, most individuals believe they own a portfolio of stocks and bonds, not a bunch of risky derivatives.