The Securities and Exchange Commission shook things up among asset managers with a proposal last December to rein in the use of derivatives by SEC-registered funds. Among other things, the SEC wants to cap the size of derivatives positions to a fixed percentage of asset value, with a higher limit for funds that pass a value-at-risk test to check whether derivatives are reducing risks or not.
Although the proposal attracted a flurry of critical comments, many also acknowledged how overdue regulation of fund derivatives was. To bolster the case for reform, the SEC conducted a study of registered funds, but only could analyse a random subset of the total $17 trillion of fund derivatives holdings, or about 1200 funds. The sheer difficulty of this exercise is the SEC’s most powerful argument.
As the SEC study points out, mainstream data providers such as Bloomberg or Morningstar that compile databases of fund holdings don’t track derivative disclosures1)See page 5, note 14: “The three vendors that provide fund holdings are Morningstar, Thomson Reuters’s Lipper, and Bloomberg. However, there are a large variety of derivatives and no standard reporting scheme exists. Many of the derivatives are OTC and customized. Even for exchange-traded derivatives, no common identification scheme like CUSIP exists. This leads to incomplete collection of information on derivatives in fund holdings. Even if derivatives are collected in fund holdings, basic descriptors such as the notional amount of the derivatives are not readily available.”. Any analysis has to start with the SEC filings and published documents of the funds themselves, which for derivatives are particularly hard to understand and inconsistent.
To appreciate the challenge facing the SEC, consider two large bond funds: Pimco’s $84 billion Total Return Fund (ticker PTTRX) and Blackrock’s $28 billion Strategic Income Opportunities fund (ticker BSIIX). Both are actively managed, and derivatives play an important role in their investment activity. In a separate article available to subscribers, we undertake a detailed analysis of their respective derivatives positions.
Would these two funds’ derivatives trades be allowable under the proposed SEC rules? Adding the notionals of the Pimco fund’s over-the-counter derivatives and repos push the total to about $190 billion – above the SEC lower limit of 150% of NAV. That’s before you add interest rate futures which have a notional of $130 billion. Taken together, this total gross notional exposure is about 370% of NAV, which breaches both the lower and upper SEC limit.
Things are almost as tricky for the Blackrock BSIIX fund. According to the fund’s June 2016 report, it had held an average derivatives notional amount of $72 billion during the first half of the year – 250% of NAV, and well above the SEC limit. However, Blackrock might draw hope from the second part of the SEC proposal, which permits a 300% NAV limit for derivatives notionals if the fund passes a VaR test.
Clearly alarmed by the prospect of having to curtail their trading, both Blackrock and Pimco wrote comment letters to the SEC in March. They argue that the SEC’s use of gross notional is flawed, and should be replaced with economic measures of exposure (such as duration) that allow economically similar trades such as Treasury bonds and interest rate swaps to offset one another. And they call for the SEC’s VaR test to be revised, permitting funds to use derivatives to adjust exposures relative to benchmarks, rather than just reduce risk.
There is some sense in these suggestions. In particular, short-term derivatives such as Eurodollar futures are much less risky than long-dated swaps. Counting their notionals equally in a leverage calculation would merely encourage funds to use riskier products, or force some types of fund, such as managed futures, to become unregistered hedge funds. Other suggestions should be treated more sceptically, such as ignoring basis risks of swaps offsetting bonds, or using an internal VaR model tailored for different fund strategies. Bank regulation has many examples of such models being gamed to arbitrage the rules.
Investors should be encouraged by the SEC’s initiative, and needn’t be alarmed by the fund industry’s complaints. Standardised disclosures of fund derivative exposures and risk profiles will shed much-needed light into this murky area. It might even force active funds to explain how their derivatives activity justifies the management fees that they charge.
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|1.||↑||See page 5, note 14: “The three vendors that provide fund holdings are Morningstar, Thomson Reuters’s Lipper, and Bloomberg. However, there are a large variety of derivatives and no standard reporting scheme exists. Many of the derivatives are OTC and customized. Even for exchange-traded derivatives, no common identification scheme like CUSIP exists. This leads to incomplete collection of information on derivatives in fund holdings. Even if derivatives are collected in fund holdings, basic descriptors such as the notional amount of the derivatives are not readily available.”|