Hungry for healthier returns, more mutual funds are investing in commodities, commodity futures, swaps and options.
In turn, regulators-particularly the
The core concern: A growing number of funds can skirt laws designed to cap their exposure to commodities.
"The mutual fund industry's
Besides over-exposure to commodities, regulators also fear inadequate disclosure of information about the brokers involved, known as futures commission merchants, or the performance of the funds that make the investments in commodities. Also unclear can be who is actually managing a fund, the fees being paid and the risks involved.
In some cases, according to the
Partly as a result, the CFTC voted earlier this month to amend Rules 4.13 and 4.5 of Title 17 of the Code of Federal Regulations to make it significantly harder for mutual funds to avoid its purview. For instance, mutual funds now must register as commodity pool operators if they trade more than 5% of their liquidated asset value in speculative commodities trading.
The commodities sector has seen an explosion in mutual fund activity, according to statistics prepared for a
According to exhibits prepared for that hearing, managers included some of the biggest names in the industry, such as the
Other big names cited include
None of these companies are the subject of federal investigations or enforcement actions, nor have they been accused of any wrongdoing, related to this issue.
Mutual fund activity in commodities grew, in part, due to relaxed regulation by both the CFTC and
For example, in 2003, the CFTC decided to loosen its rules related to registration, marketing and trading.
Before that decision, Investment Company Act of 1940 firms had to do a lot to avoid registering as a commodity pool operator with the agency.
For instance, they had to prove that their commodity and alternative trading was meant for hedging and show that any non-hedge investments did not exceed 5% of the liquidated value of their assets. The 2003 CFTC amendments eliminated those requirements, leading to a rapid influx of assets. The
The first strategy to get around that requirement involves using controlled foreign corporations to trade in commodities, as Senator Levin and his fellow investigations subcommittee member
With such companies set up, a fund would book any income generated from trades as coming from the securities held in these shell companies. The trading wouldn't count towards the cap, according to Levin and Coburn in their letter.
The second strategy, according to Levin and Coburn, would involve the issuing of "commodity-linked" notes, in which all activities tied to trading could be treated as processes related to securitization of commodities such as funding and sale of interest in these notes.
For example, he said, "one mutual fund told us all of the commodity investment decisions for their offshore corporation were made by the mutual fund's employees in
This shout-out is emblematic of the awkward situation mutual funds, and their regulators, face when it comes to investing in commodities.
Due to their structure and the 10% investment caps, these funds are forced to devise complicated strategies to invest in commodities, futures or options, if they want to use them to improve returns in funds that rely mainly on stocks or bonds.
Further, as entities largely supervised by the
"There were regulatory lapses. Pot holes," says
The CFTC, as of yet, has taken no enforcement actions against mutual funds related to these matters. Indeed, many mutual funds participated actively in roundtables on the agency's rule amendments last summer.
Nonetheless, there is a tension that can be seen in critiques published by the NFA in 2010 of three non-CFTC registered mutual funds, including one marketed by
Equinox executives did not respond to repeated requests for comment from Money Management Executive, by press time.
In the letter, the NFA found, for instance, that the prospectus materials of Equinox's
Such omissions allegedly included details about who the futures commission merchants involved were and potential conflicts of interest. Also lacking was performance information on the funds operated by the investment advisor, according to the NFA.
An important point raised in the NFA letter was the fact that the Equinox fund is targeted at retail investors and marketed as commodity futures investment.
In the case of the
The marketing material also describes it as having a "lower cost structure than most retail managed futures funds" and is the "first mutual fund to generate managed futures returns through net-long, actively managed CTAs," the NFA said.
A CTA is a commodity trading advisor, a trained expert employed by funds or sophisticated individual clients to invest in commodity instruments, who is licensed by the NFA and regulated by the CFTC.
The investment fund is now described in Equinox documents as the "first managed futures mutual fund with an actively managed portfolio of CTA programs" that "seek to to generate returns using futures contracts on financial instruments, such as currencies, treasury bonds, equity indexes, and commodities such as corn, oil, gold and sugar.''
And the documents warn potential clients that "investments in commodities, futures, and managed futures are speculative, involve substantial risk, and are not suitable for all investors. Investors should be aware that such investments can quickly lead to large losses.''
Now such funds potentially face two masters: The
"Will the regulators continue to move in tandem or will their priorities be different?" asks
The CFTC aggressively ramped up its policing in 2011. The commission said it filed 99 enforcement actions against investment funds of various types, but not specifically mutual funds. That is up 74% from the previous year.
"I think the CFTC may need to clarify what disclosures and what reporting they are looking for. Inevitably, the implementation is going to be a relatively slow process," he said.
At a minimum, there will be increased compliance controls and costs, said
She added that funds which currently use derivatives for hedging purposes or as a small part of their investment strategy may be able to continue to rely on what is left of the exemption, but will still have to build in compliance controls to make sure they stay within the rule's limits. Those that cannot will have to decide whether to change their portfolio holdings and investment strategies.
"The amended rule is likely to have a big impact on registered funds, particularly those with significant commodity strategies," said Gault-Brown.
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