SEC Commissioner Kara M. Stein provided remarks at the Brookings Institute’s 75th Anniversary of the Investment Company Act on Monday, June 15th. Now if that isn’t an exciting introduction to a post, I just don’t know what is. She addressed a topic that is of great interest to me and a focus of my research: retail/retirement investors. I tend to call them Citizen Shareholders in my writing, and it is sentiment shared by Commissioner Stein:
“By retail investor, I mean the everyday citizen or household that is investing – not institutional investors or pension funds. Eighty-nine percent of mutual fund assets are attributable to retail investors.” (emphasis added).
In her remarks she detailed several troubling aspects of the mutual fund industry–a primary investment source for retail investors– liquidity, leverage and disclosure. She also highlighted future SEC rule making initiatives related to these issues. For example, the Commission recently proposed new rules to enhance data reported to the Commission by registered funds. The proposed rule is available here (Download SEC proposed disclosure rules) and received comments can be tracked on the SEC’s website here.
Noting that a major function of the 1940 Investment Act was transparency and accuracy through disclosures, she lamented the mission drift in the mutual fund industry which she described as:
“[T]he liquidity of registered funds is one area where it seems that regulation has drifted into “buyer beware.” A retail investor looks at a mutual fund and expects that he or she will be able to get money out of a fund very quickly if needed. A retail investor is generally not performing cash flow analyses on mutual funds to test their true liquidity.”
SEC rules require redemption within 7 days and only 15% of mutual fund assets can be invested in illiquid funds. Bank loans and ETF funds, increasingly dramatically in popularity since 2009 (by over 400%) take over one month to settle and thus threaten the redemption rights and liquidity of funds in times of financial stress.
Additional “drift” comes from interpretation that the 15% threshold is at the time of purchase, not at the time of settlement so there is no true 15% threshold.
Promising high liquidity, which all mutual funds must do, on illiquid assets, that have not traditionally been a part of mutual funds, does not seem in keeping with the intent of the Investment Company Act.
Commissioner Stein identified a second problem: leverage. Another cornerstone principle in mutual fund regulation has been the requirement for relatively low leverage, as mandated by Section 18 of the Investment Company Act. Section 18 of the Investment Company Act requires low leverage with senior securities mandating a coverage ratio of 3:1 (300% asset coverage for senior securities). Commissioner Stein described the SEC’s enforcement on leverage restrictions as “ad hoc” beginning in 1970 through the 30 subsequent no-action letters issued by the Commission.
Additionally Commissioner Stein addressed the rapid evolution and popularity of alternative mutual funds that attempt to mimic hedge fund returns based on mutual fund liquidity: propositions that she finds troubling.
Assets under management in alternative mutual funds have exploded in recent years. In 2008, there were approximately $46 billion in assets under management for these funds. By the end of 2014, the number had surged to over $311 billion in assets under management. This is an increase of over 575%.
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[T]oday, alternative mutual funds promising the upside of hedge fund investments with the liquidity of traditional mutual funds are all the rage. I think that this trend should give everyone pause, and regulators and the public need to be asking questions about this development. ….. Should we consider regulating these funds differently than plain vanilla, traditional mutual funds?
Commissioner Stein’s remarks highlight several areas in the mutual fund industry that are being reevaluated by the SEC and should be interested developments to watch if you are an attorney representing mutual fund companies and investment advisers, an academic or simply an average “retail” investor.
-Anne Tucker