3.23.2009 SEC Division of Investment Management Director Andrew J. (Buddy) Donohue spoke at the Practicing Law Institute's Investment Management Institute 2009 Conference in New York. He began by reviewing the accomplishments of the Division of Investment Management in 2008, including the adoption of the summary prospectus rule.
Next, he stated that the Division continues to review and work towards modernizing the fund and adviser regulations that may have become outdated or less effective. In this regard, the Division is working on recommendations for the SEC in such areas as books and records requirements for funds and advisers, shareholder report reform, adviser custody rules and guidance to fund directors with respect to valuation of fund securities.
He then expressed his concern about the increasing use of leverage by funds. While sophisticated investors might have the ability to properly evaluate the impact of employing leverage in funds, he questioned whether many retail investors can. He noted that a fund that sought to provide a return of 200% of an index on a daily basis, apparently did so but the result in the long term was quite disappointing. The index was down about 6%, and the fund, seeking 200% of that return daily, was down over 21%. For a longer period the index was up 50 % yet the leveraged fund was actually down over 20%. He guessed that all the disclosures were there and the fund did what it said it would, but who would expect that result.
Money market fund reform was his next topic. He stated that a money market fund has the twin goals of providing liquidity, typically on a same-day basis, and preserving capital at times can conflict. In times of severe market turmoil, the twin goals may not be able to be achieved simultaneously. As an example, when liquidity is at a premium, spreads may widen considerably, thus making it more difficult to sell even the highest quality instruments at or near "amortized cost." On the other hand, a desire to maintain a $1.00 NAV can cause a fund to seek to delay redemptions or the payment of redemptions and thus fail to meet fund shareholders' expectations of liquidity.
He acknowledge that the stable $1.00 NAV of a money market fund is a popular feature. However, in his view, it presents certain potential drawbacks to investors.
First, the choice of $1.00 instead of $10.00 per share NAV has made the NAV quite insensitive to losses and gains in the funds' portfolios until, once they reach 0.5%, the share price rises or falls a full 1.0%. That means that while price changes can be expected to be infrequent, when they do occur, they will be fairly dramatic.
Second, this lack of sensitivity to volatility affords investors, particularly large investors, the opportunity to take advantage of the fund and its other shareholders. He provided the following example: assume a money market fund has a loss on investments of 0.40% so that its NAV is now $0.9960, which is $1.00 and within the 0.5% deviation permitted under current rules. If investors who own 25% of the fund redeem at $1.00, the NAV is now $0.9947 or $0.99 per share. Sophisticated investors know this dynamic and will redeem their shares in the fund quickly, leaving the loss for the remaining shareholders. What had been a loss of 40 cents on $100.00 for remaining shareholders is now $1.00 on $100.00 because they did not abandon the fund quickly enough. He questioned whether this is appropriate and whether it increases the possibility and probability of a run on a money fund.
Third, the $1.00 price may not provide investors with adequate information regarding their investment. As with the previous example, an investor purchasing at $1.00 when the NAV was $0.996 had no way to know that he (she) was at risk of losing 1% in one day merely because of redemptions by others or other minor valuation moves. These problems could be addressed by the adoption of a $10.00 NAV or a floating NAV. He believed these important issues must be considered when approaching money market fund reform. He added that the review of the money market fund model and its regulatory regime is one of the top priorities in the Division of Investment Management this year.
His last topic was ETFs. He stated that ETFs have become a popular and important financial component of our financial markets since the launch of the first ETF, SPDRs, in 1993. Because of their unique structure, ETFs must obtain exemptive orders under the Investment Company Act before they can operate. The SEC has issued about 70 of these orders, and the ETF marketplace has grown to approximately 680 ETFs with a total of about $400 billion in assets.
The SEC has issued orders to permit the operations of leveraged ETFs, and last year, the SEC issued the first orders to allow actively managed ETFs with fully transparent portfolios. The Division has received some applications for actively managed ETFs with non-transparent portfolios, although none has been approved to date. As ETFs have evolved, the regulation of these products also has evolved.
Click http://www.sec.gov/news/speech/2009/spch040209ajd.htm to access the speech.