Will SEC Crash the Liquid Alts Party?

Mutual funds that use managed futures have grown dramatically in popularity, but the SEC is troubled by their leverage — and that troubles the industry

Investing in a mutual fund is relatively simple for all groups, but mainly for the retail public who want access to a wide variety of largely stock-based funds for a minimum investment and hopefully get some upside in a diversified number of markets. Several years ago, the managed futures business worked out a method to provide funds with a derivatives twist.

It confounded the Securities and Exchange Commission at first, and then as the number of these funds grew, it meant comprehensive legislation was needed. When the Jumpstart Our Business Startups (JOBS) Act was passed in 2013, it gave credence to these derivatives-based “'40 Act” funds, and they grew astronomically.  

The SEC’s own Division of Economic and Risk Analysis noted that alt strategies funds (defined as including alternative funds, commodity funds and nontraditional bond funds) comprised 3% of the total $17.9 trillion registered mutual fund business in 2015. While the total of registered funds grew by 8% per year between 2010 and 2014, alt strategies fund numbers grew at an annual rate of 17%.  

There’s justification for their popularity. With such funds, the retail investor can access the trading prowess of an AQR Capital Management or Campbell & Co. commodity trading advisor (CTA) for a minimum investment and have the usual protections of a mutual fund.

Just recently, Societe Generale launched the ’40 Act CTA Mutual Fund Index, which is made up of the 10 largest single-manager CTA mutual funds and is calculated daily (See SG CTA Mutual Fund Index at BarclayHedge.com). Through February 19 the index was up 3.82%, while the S&P 500 was down 6.17%.

AQR Capital Management, which has a total of $141 billion under management and offers the largest number of ‘40 Act Mutual Funds, is one of the top funds in the index. Its Managed Futures Strategy Fund (AQMIX) has averaged just over 4% annually over a five-year period. Its HV fund (Class I), launched in 2013, already has $590 million under management, a minimum $5,000 investment and an average annual return of 11%. It has a management fee of 1.45% with no incentive fee.

Cliff Asness, managing and founding principal of AQR, has said they’ve been known as the “fair fee guys” and in some ways have been “rewarded for our virtue” with its incredible growth.

Yet a dark cloud hovers over these funds, as well as leveraged ETF funds, with the SEC’s rule proposal 18f-4, which aims to “provide a more comprehensive approach to the regulation of funds’ use of derivatives.”

The rule basically provides two measurements to limit leverage on funds that use derivatives while maintaining an amount of certain assets within the fund to “meet obligations under its derivatives transactions,” both of which would rein in leverage. It also would require a board approved risk manager.

Almost all the comment letters so far (about 100) come from the ETF side, which might be most affected, and from individual investors who like their leverage. The response from the managed futures side has been muted.

Annette Cazenave, principal of A. Cazenave LLC, who has been in the managed futures business for decades, says futures managers already use a value-at-risk measuring stick, have a risk manager, especially big firms like AQR, and probably wouldn’t be too affected by the leverage limitations, although she adds that would probably hurt investors more because it limits the upside.

AQR, which on the managed futures side might have the most to lose if this sort of rule goes through, was stoic in its January public statement, saying, “The ultimate rule could differ substantially from the proposal given the amount of feedback the SEC is seeking.” It added: “We welcome clear guidance around how mutual funds can use derivatives and a robust set of rules to ensure proper use and investor protection.” That said, AQR noted it was sure it could “adapt” to rules ultimately adopted.

Final comments from the bigger players on both the managed futures and ETF business side have yet to be filed before the March 28 deadline. When they are, and when the final rule is in place, it probably will “differ substantially” from what the SEC threw on the fire, Cazenave predicts.

It’s apparent there is a long tail to this review process as these large companies have more to lose than the individual investor. Cazenave predicts nothing will happen until next year. In that case, the best advice for investors in managed futures mutual funds and leveraged ETFs may be to stay put.

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