SEC threatens survival of alternative mutual funds

Hedge funds have been having a hard time since 2015, with markets putting a stop to their bullish trends from as far back as 2009, drowning market driven returns (beta) and lowering expected returns for diversified portfolios.

Cloud-based institutional and hedge fund investment research provider eVestment reported recently that hedge fund volume had declined by 40% in 2015, and according to Hedge Fund Research, more than 600 hundred hedge funds closed in the first three quarters of 2015 as tide turned and left many sinking.

Putting things in perspective, it is important to acknowledge that given the all-time high number of hedge funds (over 10,000), the absolute number of dropouts (and entrants) is also high.

The Securities and Exchange Commission, however, is posing a new threat to a specific class of funds, the “alternative mutual funds” or “hedged mutual funds”.

This new type of mutual funds, incubated in the last few years thanks to a combination of industry shifts and regulatory changes, delivers hedge fund-like exposure in a mutual fund structure, employing leverage, derivatives, and short selling, unlike traditional “long-only” mutual funds, and gaining access to strategies including merger arbitrage, convertible arbitrage, macro trading and long/short equity.

The SEC is planning to cap funds’ exposure to derivatives at 150% of their net assets, also requiring them to hold more liquid (cash and cash equivalent) assets as a buffer against potential losses.

The SEC considers derivatives as borrowing, given the outsize bets with a small down payment allowed by and the respective fees in exchange for assuming a larger potential liability.

According to an SEC study published in December, 27% of alternative mutual funds hold derivatives “whose notional value exceeds the proposed ceiling” and 450 mutual funds would exceed the 150% threshold.

From these, 200 are bond funds that use derivatives to boost returns. The same study found that an average managed futures fund held derivatives equal to about 450% of net assets. To comply with requirements, these funds would have to sell assets or shut down their retail market operations.

These potential requirements, still under evaluation by the regulatory authorities, follow recent efforts to curb chances of repeating a financial crisis like the one in 2007-2008. Curiously, it was precisely since the Dodd-Frank Act that these alternative mutual funds found their place in the market.