Late last year, the SEC proposed a new rule, Rule 18f-4, applicable to investment companies (including mutual funds and exchange traded funds), which will place significant restrictions on an investment company’s ability to use derivatives. Under the proposed Rule, funds registered as investment companies will be required to comply with one of two enumerated limitations - the Exposure-Based Portfolio Limit or the Risk-Based Portfolio Limit.
The Exposure-Based Portfolio Limit requires a fund to limit its exposure to 150% of the fund’s net assets. Under this limit, a fund’s “exposure” would be calculated as the aggregate notional amount of its derivatives transactions, together with its obligations under financial commitment transactions and certain other transactions.
The Risk-Based Portfolio Limit would permit a fund to obtain exposure up to 300% of the fund’s net assets, provided that the fund satisfies a risk-based test (based on value-at-risk or VaR).
Additionally, a fund would be required to manage the risks associated with its derivatives transactions by segregating certain assets (primarily cash and cash-equivalents) equal to the sum of the “Mark-to-Market Coverage Amount” and the “Risk-Based Coverage Amount.” For the Mark-to-Market Coverage Amount, a fund would be required to segregate assets equal to the amount the fund would pay if the fund exited the derivatives transaction at the time of the determination. For the Risk-Based Coverage Amount, a fund would also be required to segregate an additional amount representing a reasonable estimate of the potential amount that the fund would pay if the fund exited the derivatives transaction under stressed conditions.
Funds which use more than limited derivatives transactions or enter into complex derivatives transactions would also be required to adopt a formal risk management program approved by the fund’s board of directors. In such a case, the fund would also be required to appoint a risk manager approved by the fund’s board of directors. For transactions which may require a financial commitment, the fund would be required to segregate the total amount that the fund is conditionally or unconditionally required to pay or deliver under such transactions.
The comment period on proposed Rule 18f-4 closed in March of this year. Approximately 180 comments were submitted by a wide variety of industry participants as well as customers, trade associations and representatives of interested parties. Comments generally included support for the Rule, criticism and suggestions as to the calculation of the limits and segregation requirements, and outright opposition of the Rule. In regards to the Exposure-Based Portfolio Limit, some commentators suggested that instead of relying upon the notional value of the derivatives transaction, a better measure would be a margin-based value. In addition, some commentators took issue with the segregation requirements and the limitation of only utilizing cash or cash-equivalents, instead of other liquid assets of the fund.
While some traditional investment companies utilizing derivatives will no doubt be affected by the Rule if adopted, those hardest hit by the Rule will be managed futures funds. For those managed futures funds that cannot meet the requirements, alternatives will be to become a private fund offering its interests pursuant to Regulation D or become a public commodity pool relying on registration under the ’33 Act instead of the ’40 Act. Since the comment period has expired, the SEC will need to consider the comments and its options. First, the SEC can adopt the Rule as is, and the Rule could become effective no less than 60 days after publication. However, based on the number of comments, the substance of the comments, the significance of the Rule and the length of time since the SEC has previously addressed the use of derivatives by investment companies, the SEC could also re-propose the Rule taking into account the suggestions and feedback from commentators.