Regulatory support and the need for Alternative Mutual Fund research

Thursday, February 7th, 2019 and is filed under AI Insight News

Some financial firms have raised questions about the need for conducting additional research on alternative mutual funds given their complex structure compared to traditional mutual funds. See below for supporting regulatory detail to help differentiate the need for additional due diligence on alternative mutual funds.

In 2013, FINRA issued an alert identifying alternative mutual funds as having unique characteristics and risks separate from their traditional counterparts (stock and bond funds). The alert, Alternative Funds Are Not Your Typical Mutual Funds, focuses on defining liquid alternatives, how they compare to hedge funds, and what all investors need to be aware of. 

Liquidity Risk Management proposed on September 22, 2015. The proposal included a comprehensive package of rule reforms designed to enhance effective liquidity risk management by open-end funds, including mutual funds and exchange-traded funds (ETFs). Under the proposed reforms, mutual funds and ETFs would be required to implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. The proposal is designed to better ensure investors can redeem their shares and receive their assets in a timely manner.

Derivatives Rule proposed on December 11, 2015. The rule is designed to enhance the regulation of the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds (ETFs) and closed-end funds, as well as business development companies. The proposed rule would limit funds’ use of derivatives and require them to put risk management measures in place which would result in better investor protections.

• The fate of the Derivatives Rule, which would impose aggregate exposure limits on a fund’s net assets, has become uncertain. The rule was proposed under the previous administration and former SEC Chair Mary Jo White. However, under the spring 2018 regulatory agenda for the division of investment management, it was recommended that the Commission revisit the rule. The SEC did ultimately adopt the Liquidity Risk Management Program Rule, in which funds will have to comply (generally speaking) with the new requirements imposed by June 2019. The rule requires each registered open-end management investment company, including open-end ETFs, but not including money market funds, to establish a written liquidity risk management program. The program requires each fund to classify the liquidity of its portfolio investments based on the number of days within which it determined that it reasonably expects an investment would be convertible to cash.
• The rule also requires funds to review its portfolio investments’ classifications at least monthly. Also, funds must determine their “highly liquid investment minimum,” or the minimum amount of the fund’s net assets it invests in highly liquid investments to increase the likelihood that it will meet redemption requests without significantly impacting its NAV. Given the nature of alternative mutual funds and its use of derivatives, investors should be aware of the associated risks fund managers face in complying with the rules and incorporate an understanding of the systems and programs in place as part of fund due diligence.

In 2017, FINRA took further steps to identify alternative mutual funds as a unique product set by introducing an e-learning course titled Understanding Alternative Mutual Funds. The course explains the unique characteristics and associated risks of these investments, and presents scenarios designed to further the understanding of the complexities and the importance of performing a thorough suitability analysis.

Additional Resources:

• FINRA NTM 12-03: Heightened Supervision of Complex Products
• White Paper: Understanding the Complexities of Liquid Alternatives