Friday, April 9, 2010

Mutual Funds Draw Derivatives Scrutiny

Mutual Funds Draw Derivatives Scrutiny
SEC Looking at Disclosure, Oversight

By DAISY MAXEY

The use of derivatives by mutual funds has caught the eye of regulators, concerned that these complex instruments pose risks that aren't fully understood.

It is safe to say that many investors, and even their advisers, can't easily determine the extent to which the funds they choose are using derivatives, including futures, options, swaps and other instruments.

While more often associated with hedge funds and the more exotic types of exchange-traded funds, such as those that use leverage, derivatives are in fact employed to some extent by many different types of mutual funds.
SEC Reviewing Use

The Securities and Exchange Commission said in March that it is reviewing the use of derivatives by mutual funds, exchange-traded funds and other investment companies. It plans to explore, among other issues, whether current practices are in line with federal rules on leverage, concentration and diversification, and whether funds manage and disclose risk appropriately. It also will look at whether their boards are providing enough oversight.

The review is likely to focus on the over-the-counter market, especially for interest-rate and credit-default swaps, which are used by firms including BlackRock Inc., Allianz SE's Pimco, and Western Asset Management Co., a unit of Legg Mason Inc., said Michael Herbst, an analyst at Morningstar Inc. Over-the-counter derivatives are traded privately rather than through commodity exchanges, which are regulated by the Commodity Futures Trading Commission.

Those three managers are some of the biggest users of derivatives, Mr. Herbst said. "A wide range might use them a bit more sparingly." Among the reasons for using them, he said, would be to gain or magnify exposure to markets or interest rates, and to hedge against risk in a portfolio.

Some investors may be surprised to learn that many core bond mutual funds use derivatives extensively. Among them are Pimco Total Return Fund (trading symbol PTTAX) and BlackRock Total Return Fund I (MDHQX) and II (BCBAX), Mr. Herbst said. In addition, Western Asset Management Core (WACSX) and Western Asset Core Plus (WAPSX) funds have used them in the past, but probably do so a little less today, he said.

Western Asset Management confirmed that its Core and Core Plus funds are using derivatives less. The asset manager discloses all of its holdings in its annual reports, a spokeswoman said.

BlackRock declined to comment on its funds' use of derivatives, and Pimco didn't respond to a request for comment.

Mutual funds disclose their use of derivatives in annual and semiannual statements, but this doesn't always make the extent or type of exposure clear.

Mr. Herbst noted that, even when they are disclosed, the risks may remain unclear.

"A manager may buy one type of derivative, then buy another type to offset the first," Mr. Herbst said. "Something managers themselves have been wrestling with is how to better disclose that type of exposure to investors."

Dylan Cathers, an analyst with Standard & Poor's Equity Research, said investors would be better served by a plain-English document in which managers explain clearly and in detail what derivatives they are using and why.

Still, he added, "At the end of the day, it's the advisers' and the investors' responsibility to really look into the funds on their own."
Higher Costs?

Mr. Cathers and others noted that, should increased regulation result from the SEC review, it may have a downside in higher costs for mutual funds.

Mr. Jacobson said regulators appear to be focusing on disclosure issues, which is a good approach. "Derivatives are tools that can be used for tremendous advantage and can be abused to create serious problems. It's practically useless to ban many of them entirely because the industry will simply design something similar that will do essentially the same thing."

2 comments:

Seenath Kumar said...

Really thanks for sharing this information hoping to get more updates on mutual fund.

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