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SEC’s Stein Expects Fiduciary Rule, Sees ‘Cracks’ in Registered Funds

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While the “legal framework” of the nearly 75-year-old Investment Company Act of 1940 has enabled strong growth in mutual funds and ETFs, SEC Commissioner Kara Stein voiced her concern Wednesday that “some cracks” are starting to appear in the framework’s foundation, particularly regarding bank loans, ETFs and alternative mutual funds.  

Noting the agency’s continued work on rule proposals to enhance data reporting for registered investment companies, which include mutual funds and ETFs, Stein said Wednesday, during a speech at the Brookings Institution in Washington on mutual funds over the next 75 years, that it’s important to assess how the Investment Company Act is working — or not.

Stein also said that she expects the Securities and Exchange Commission to be presented with a uniform fiduciary rulemaking by Chairwoman Mary Jo White. “The devil will be in the details on what that proposal will look like,” Stein said. “If it were simple,” Congress would have told the SEC how to implement such a standard in the Dodd-Frank Act statute.

The agency, Stein continued, has to “think about the intended and unintended consequences” of a fiduciary rulemaking. She noted the Department of Labor’s fiduciary reproposal is looking at who’s a fiduciary under the Employee Retirement Income Security Act, “which is different” than securities laws under the SEC’s purview.

“We need to have these robust policy debates” around the fiduciary issue, Stein said. “This [fiduciary rulemaking issue] is not easy, and there is no one silver bullet solution.”

As to registered funds, Stein said that “it appears registered funds have slowly drifted toward a more flexible and permissive disclosure regime,” which “increasingly places the onus on the retail investor to figure out whether a fund is right for him or her.” But retail investors, “who generally tend to be less sophisticated in financial matters, might not even understand what he or she needs to know to make that decision.”

For example, she continued, “the liquidity of registered funds is one area where it seems that regulation has drifted into ‘buyer beware.’”

The importance of registered funds going forward, she said, can’t be understated.

Over the next 35 years, she said, the senior population in the U.S. is expected to “swell.” Figures estimate that roughly 15% of the total population now is 65 or older, or approximately 46 million Americans. By the year 2050, there are projected to be nearly 88 million Americans age 65 and older, which is roughly 22% of the total projected population, she said.

Since the Investment Company Act was set up, the American mutual fund and ETF market has become the largest in the world, with nearly $18 trillion in assets under management at the end of 2014 — which is more than 50% of the worldwide market. “If you have a 401(k) plan for your retirement savings or a 529 plan for a child’s college education, you likely are an investor in a registered fund,” she said.

Stein noted the proposed new rules the agency is working on to improve the data that registered funds report to the Commission and to the public, as well as SEC staff examining potential changes to liquidity management rules and derivative rules for registered funds. “All of this comes,” she said, “against the backdrop of the Financial Stability Oversight Council and others taking a closer look at the potential systemic risks posed by asset managers and registered funds.”

Of concern are alternative mutual funds, which Stein said “often operate in a gray area of mutual fund regulation. Most would not have envisioned these funds taking off even a couple of decades ago.”

Liquidity, leverage, derivatives and investor protection are also “elements that should be present in any discussion about alternative mutual funds,” Stein said. “It is hard to define what an alternative mutual fund is. It can mean different things to different people.”

Generally, however, they are mutual funds or ETFs that pursue an investment strategy in a nontraditional asset class, use nontraditional investment strategies, and/or invest in illiquid assets, Stein explained, and they “also frequently seem to rely on derivatives for their investment returns.”

Said Stein: “We all need to be asking questions about the development of these funds and what they mean to the retail investor. Do investors understand these products? Are these funds adhering to the foundational principles of the Investment Company Act?”

Stein also voiced her concerned about what she views are “new, complicated registered funds” that have entered the marketplace. For instance, registered funds that invest in bank loans, “which have become popular.”

Since late 2009, assets in bank loan mutual funds and ETFs have increased by almost 400%, Stein said, “yet many of the underlying loans in these funds may take over a month to actually settle. If it takes over a month to settle, it is reasonable to wonder how the fund could possibly meet the seven-day redemption requirement in the Investment Company Act in times of market stress.”

Also, she said, “these bank loan funds may be comprised almost entirely of illiquid bank loans, which would seemingly violate the 15% threshold.” (SEC guidance only allows mutual funds to invest up to 15% of the fund’s assets in illiquid securities.)

“Some may also invest in collateralized loan obligations (CLOs). How is this happening?”

Stein said she hopes the Commission “considers action in the area of liquidity” and asks “hard questions about new and innovative products, as well as emerging risks.”

“What happens to an open-end mutual fund or ETF — which must honor redemptions in seven days — when financial conditions get rocky, redemption requests surge, and the fund is primarily invested in illiquid assets?” she said.

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