New York, NY
Oct. 29, 2014
Good morning everyone, and thank you, Tracy, for that kind introduction and for inviting me to speak here today. Before I begin, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any other colleague on the staff of the Commission.[1]
I was glad to be asked to speak at this forum, because I believe the purpose of this forum—to discuss the issues, challenges and opportunities related to complex products—is extremely relevant in today´s environment. This group in particular represents companies who are frequently at the forefront of innovation in the asset management industry. Before joining the SEC in 2010, I worked in and around the private fund industry for more than fifteen years, and I experienced firsthand the tremendous amount of work that goes into creating evolving investment products and strategies.
I continue to believe that innovative products can help meet the ever-evolving demands of investors, and the Division has become increasingly focused on how we as regulators can effectively monitor the risks associated with such products. The Division of Investment Management´s mandate in this landscape is clear—our mission is to protect investors, promote informed investment decisions, and facilitate appropriate innovation in investment management products and services. The Division´s staff possesses a deep understanding and mastery of the more traditional work of the Division and has increasing expertise in specialized financial services and complex products. I work with almost 200 smart, highly motivated people who are committed to carrying out the Division´s critical mission in an economy that is constantly growing, innovating, and changing.
Today, I would like to discuss the Division´s enhanced risk monitoring efforts in the asset management industry and then discuss alternative mutual funds, one area where we have seen significant growth recently.
The Commission continues to be very focused on risk monitoring and data gathering, especially as products and markets become more complex and as the risks facing the industry evolve. To that end, we have enhanced the Division´s ability to monitor and better understand the investment management industry—both by launching new initiatives to monitor risk and by sharpening the existing tools at our disposal. We gather and analyze data and monitor risk through a number of avenues, including, but not limited to, (1) the routine review of requests for no-action and exemptive relief and disclosure filings, (2) our senior level engagement program, (3) our industry monitoring program, (4) our expert staff, and (5) coordination with other offices in the Commission. Our data gathering and risk monitoring efforts are an integral part of the entire Division´s work and together contribute to our ability to make better and more informed policy recommendations to the Commission and put out guidance to our stakeholders.
The Division´s role of reviewing requests for no-action and exemptive relief and disclosure filings is one way that we monitor new trends and their associated risks. We view the exemptive application process as the laboratory where we examine new ideas from market participants. As you may know, it was through the exemptive relief process that money market funds and exchange-traded funds (ETFs) started. Reviewing requests for no-action and exemptive relief provide the staff with an opportunity to consider the benefits of new products but also anticipate the potential risks to investors and to the market. Over the last few months, we evaluated the potential risks associated with a proposed non-transparent ETF structure. Last week, the Commission issued two notices indicating the Commission´s intention to deny two applications for exemptive relief to launch such ETFs.[2]
The Division´s role of reviewing disclosure and fund financial reporting also affords the staff a unique position to identify and monitor industry-wide risks. For example, last year, our disclosure review staff noticed an increase in the number of funds using the word "protected" in their fund names. The staff raised concerns that when a fund´s name suggests safety or protection from loss, an investor may misunderstand the risks associated with an investment in the fund. To clarify the staff´s position on the use of words like "protected" in a fund´s name, the staff issued a Guidance Update in November 2013 articulating the staff´s concerns.[3]
This is an excellent example of how the Division´s data gathering and trends monitoring helps us to think about areas where we as regulators can protect investors and provide further guidance to our stakeholders. We aim to clarify the staff´s views by issuing IM Guidance Updates. We see Guidance Updates as meaningful communications representing the staff´s thinking on discrete issues, not as substitutes for the established rulemaking, exemptive application and no-action processes. In a former life, I served as a General Counsel and Chief Compliance Officer and advised on investment management regulatory matters in both the in-house and outside counsel roles. In those roles, I found that guidance from the Commission and its staff was extremely beneficial in making the right calls and promoting a culture of compliance. I appreciate that interpretive ambiguity can have a dampening effect on pursuing innovative ideas. We see the Guidance Update process as another avenue to remove uncertainty and improve the public´s understanding of the staff´s view on critical issues. I believe these goals are particularly relevant as new and existing products become increasingly complex.
One way that we have enhanced our risk monitoring efforts is through our senior level engagement program. Through this outreach initiative, senior leadership of the Division has met and continues to meet with senior management and fund boards at several of the country´s large asset managers. To ensure that we meet with a representative sample of different firms, we consulted with the Office of Compliance Inspections and Examinations, or OCIE, and used a quantitative and qualitative approach to select a diverse cross section of firms based on their size, activity mix, product mix, and geography. I believe these meetings are extremely useful in promoting two-way communication between the industry and the Commission staff. We hope that by meeting with fund boards and executives in a non-examination setting, we can talk openly about potential issues before they arise.
We also believe this senior level engagement program will help us to better understand the workings of the industry we regulate. These engagements give the Division a "finger on the pulse" of registrants, which has proved invaluable when an issue arises in the industry. In these discussions, we have learned a great deal about the identification and management of risk—risks specific to particular firms or funds, as well as critical risks facing the industry as a whole. These meetings allow us to obtain a focused and informed view of the systems, controls, and personnel of an individual firm. Communicating with the industry in these meetings and more broadly also results in better policy recommendations and helps us to identify Division policies that could benefit from greater clarification—many of the topics for our IM Guidance Updates arise from questions or comments that we receive directly from industry participants, and we encourage stakeholders to contact the staff with their questions or comments.
The Division also conducts ongoing quantitative and qualitative financial analysis of the investment management industry—with a particular focus on strategically important investment advisers and funds—through our industry monitoring program. Our analysis of the data that the Commission gathers enhances the Division´s ability to protect investors. For instance, after fixed income markets experienced increased volatility in June 2013, we examined developing trends in the fixed income market and released an IM Guidance Update on risk management in changing fixed income market conditions. The Guidance Update suggested certain steps for fund advisers to consider with respect to risk management and disclosure matters relating to changing market conditions.[4] Also, in 2013, an ongoing analysis of money market fund data led to an enforcement action against Ambassador Capital Management. During our review of the gross yield of funds as a marker of risk, we identified the Ambassador Money Market Fund as consistently different from the rest of the market. We brought this to the attention of OCIE, the matter was referred to the Enforcement Division´s Asset Management Unit for further investigation, and then the Commission brought fraud charges against the advisory firm and portfolio manager.
The Division has also been proactive in monitoring events—such as geo-political, natural disaster, and market events—that may impact funds and advisers. When such events occur, we have focused on maintaining communication with affected asset managers and funds, reviewing disclosures to investors, and assessing the impact on investors´ ability to access funds or trade securities.
Furthermore, the Division´s Risk and Examination Office, or REO, in addition to participating in the senior level engagement program, has the ability to conduct its own targeted exams of investment advisers and fund complexes. REO generally also coordinates with OCIE to gather information for policy issues during OCIE´s regular examinations of firms. We learn a great deal about firms from the examination process, and what we learn helps to inform our policy recommendations.
Many of our enhanced risk monitoring efforts would not have been possible without our expert staff. The Division´s staff has always had an unparalleled depth and breadth of knowledge and understanding of the traditional work of the Division and has always used these tools to help the Division fulfill its mission. Over the past few years, we have added to our expertise by hiring quantitative experts, industry experts, examiners, lawyers, and accountants, and I continue to be impressed by the level of expertise and dedication that these individuals have brought to the Division.
Earlier this month, I was in a meeting about our data gathering project where we are considering recommending that the Commission propose substantial improvements to the forms the Commission uses to gather data from mutual funds. We had a group of former portfolio managers, PhD economists, quantitative analysts, lawyers, accountants, and industry experts in derivatives and ETFs all gathered together in one room. When the group began debating risk measures, it occurred to me how extremely fortunate we are to have hired such intelligent people dedicated to protecting our country´s investors. I also realized that only five years ago, when I joined the Commission, many of these experts were not at the Commission. It struck me how this wealth and diversity of knowledge and expertise makes our policy recommendations that much more informed and nuanced.
In addition to our data gathering project, all of our risk monitoring efforts are helping us make better and more informed recommendations with respect to other potential policy matters. For example, as many of you know, the Commission issued a concept release in 2011 on mutual funds´ use of derivatives. Our risk monitoring efforts are augmenting our continued study of the comments we received and are helping shape the potential policies we are considering in this area. Further, among the initiatives we are considering are expanded stress testing of the largest asset management firms. I believe that our enhanced risk monitoring efforts serve as one of the Division´s most important modern tools to develop effective policies needed to address risks.
The focus on risk monitoring and risk-based analytics is not limited to the Division of Investment Management. The Commission as a whole has been focused on ways to better utilize the data it obtains through its monitoring efforts. For example, the staff now has access to a powerful new analytical tool called MIDAS (Market Information Data Analytics System), which collects about 1 billion daily records from the proprietary feeds of each of the 13 national equity exchanges time-stamped to the microsecond. In addition to MIDAS, the Quantitative Analytics Unit in the Commission´s National Exam Program has also developed groundbreaking new technology that allows examiners to access and systematically analyze massive amounts of trading data from firms in a fraction of the time it would have taken in years past. And I believe that these new analytical and risk-monitoring tools will continue to improve the Commission´s ability to protect investors.
One of the trends that the Division identified through our ongoing analysis of industry data and our review of disclosure filings is the rapid and significant growth in alternative mutual funds.[5] As of the end of September 2014, alternative mutual funds had over $282 billion in assets. Although alternative mutual funds only accounted for 2.3% of the mutual fund market as of December 2013, the inflows into these funds in 2013 represented 32.4% of the inflows for the entire mutual fund industry, with almost $95 billion of inflows into alternative mutual funds in 2013. That is over five times more than the amount of inflows into alternative mutual funds in 2012.[6]
I previously discussed alternative mutual funds on two recent occasions. In June, I outlined the heightened risks faced by alternative mutual funds with respect to valuation, liquidity and leverage and the role that fund boards play in the oversight and compliance programs of alternative mutual funds.[7] In September, I focused my remarks on the importance of a focus on compliance and the interests of investors for advisers launching alternative mutual funds.[8] Today, I would like to concentrate on the challenges of appropriately disclosing the heightened risks of alternative mutual funds to retail investors.
My colleague Andrew Bowden, the Director of OCIE, has compared alternative mutual funds to bright, shiny objects—bright, shiny objects that are sharp.[9] Many investors have benefitted from including alternative mutual funds in their portfolios, as they provide retail investors access to investment strategies that were previously only accessible to investors in private funds. Alternative mutual funds generally pursue strategies that seek to produce positive risk-adjusted returns (or alphas) that are not closely correlated to traditional investments or benchmarks. Investors may also be attracted to alternative mutual funds because of the very characteristics that differentiate these registered funds from their private fund counterparts. For example, in comparison to private funds, mutual funds may provide greater investment liquidity, greater portfolio transparency, lower advisory fees, lower investor minimum requirements, and no minimum eligibility requirements.
However, I believe that several areas—such as valuation, liquidity, and leverage—present heightened risks for mutual funds when they pursue alternative investment strategies. These heightened risks and the complex nature of the investment strategies employed by alternative mutual funds can make the goal of clear, concise disclosure more difficult to attain. The prospectus disclosure requirements of Form N-1A are intended to elicit information for an average or typical investor who may not be sophisticated in legal or financial matters,[10] but as fund strategies become more complex, ensuring that the average investor has the information he or she needs to make informed investment decisions becomes more challenging. To muddy the waters further, the staff has raised concerns that there could be a disconnect between the strategies and risks that a fund discloses in its prospectus versus the strategies that the fund actually employs. Obviously, such a disconnect would make it even more difficult for investors to determine whether a product is a suitable investment for them.
The Division recognizes the challenges that funds face in writing clear, concise disclosure about complex products, and we have provided guidance on how the Division views disclosure relevant to funds that engage in alternative investment strategies and invest in alternative assets. In July 2010, the Division´s Disclosure Review and Accounting Office provided some observations about the then-current derivatives-related disclosures by investment companies in registration statements and shareholder reports.[11] We re-emphasized the importance of clear, concise disclosure and described our expectations in our August 2013 Guidance Update discussing "Disclosure and Compliance Matters for Investment Company Registrants That Invest in Commodity Interests."[12]
The staff generally believes that all funds that use or intend to use alternative investment strategies should assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner using plain English. Disclosure of principal investment strategies should be tailored specifically to how a fund expects to be managed and should address those strategies that the fund expects to be the most important means of achieving its objectives and that it anticipates will have a significant effect on its performance. In determining the appropriate disclosure, a fund generally should consider the degree of economic exposure the alternative investment strategy creates, in addition to the amount invested in that strategy.For instance, staff believes that a small investment in some derivatives does not necessarily correlate with little effect on a fund's performance because of the impact of leverage. On the other hand, staff has observed that a fund may have significant exposure to derivatives, but that exposure may not make the fund substantially riskier.[13]
The staff also generally believes that the risk disclosure in the prospectus for each fund should provide an investor a complete risk profile of the fund´s investments taken as a whole, rather than a list of various investment strategies, and reflect anticipated alternative investment or asset usage. We note that investment strategies that employ derivatives, including commodity interests, may introduce risks in addition to those associated with investments in the cash markets, and that we expect funds that use such strategies to address those risks in their disclosures where the information is material to investors. An alternative mutual fund should, for example, disclose material risks relating to volatility, leverage, liquidity and counterparty creditworthiness that are associated with trading and investments in alternative investment strategies, such as derivatives, that are engaged in, or expected to be engaged in, by the fund.
Finally, the staff generally believes that a fund should assess on an ongoing basis the completeness and accuracy of alternative investments-related disclosures in its registration statement in light of its actual operations. The Division´s staff has been reviewing data to compare the actual use of alternative investment strategies with what has been disclosed in fund disclosure documents. Based on these reviews, the staff believes that a fund generally should assess, based upon its actual operations, whether it is meeting the requirements to completely and accurately disclose its anticipated principal investment strategies and risks. A fund generally should review its use of alternative investment strategies when it updates its registration statement annually and assess whether it needs to review the disclosures in its registration statement that describes its principal alternative investment strategies and risks. A fund should also generally consider the accuracy and completeness of marketing materials related to its investment objectives and performance.
As I have highlighted above, alternative mutual funds face significant challenges when it comes to writing clear, concise prospectus disclosure. I cannot emphasize enough the importance of ensuring that retail investors have the information they need to make informed investment decisions, especially with respect to alternative mutual funds and other complex products.
Thank you for your attention. I encourage you to keep up our dialogue. Please continue to approach me and the staff with your thoughts for areas where our guidance may be helpful, and continue to develop the innovative ideas that will meet the new challenges faced by investors in the twenty first century.
[1] I would like to thank Stephanie Hui for providing vital assistance in preparing these remarks. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author´s views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
[2] See Investment Company Act Release No. 31300 (Oct. 21, 2014), available at http://www.sec.gov/rules/ic/2014/ic-31300.pdf and Investment Company Act Release No. 31301 (Oct. 21, 2014), available at http://www.sec.gov/rules/ic/2014/ic-31301.pdf.
[3] Fund Names Suggesting Protection from Loss, IM Guidance Update No. 2013-12 (November 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-12.pdf.
[4] Risk Management in Changing Fixed Income Market Conditions, IM Guidance Update No. 2014-01 (January 2014), available athttp://www.sec.gov/divisions/investment/guidance/im-guidance-2014-1.pdf.
[5] "Alternative mutual funds" refers to certain open-end mutual funds registered under the Investment Company Act of 1940. 15 U.S.C. 80a. While there is no clear definition of "alternative" in the mutual fund space, an alternative mutual fund is generally understood to be a fund whose primary investment strategy falls into one or more of the three following buckets: (1) non-traditional asset classes (for example, currencies), (2) non-traditional strategies (such as long/short equity positions), and/or (3) illiquid assets (such as private debt).
[6] Based on staff analysis of Morningstar DirectSM open-end mutual fund data.
[7] Norm Champ, Remarks to the Practising Law Institute, Private Equity Forum (June 30, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370542253660.
[8] Norm Champ, Remarks to the Practising Law Institute, Hedge Fund Management Seminar 2014 (Sept. 11, 2014), available at http://www.sec.gov/News/Speech/Detail/Speech/1370542916156#.VEZc4jYpBCo.
[9] Andrew Bowden, People Handling Other Peoples´ Money, Investment Adviser Association Compliance Conference (March 6, 2014) available at http://www.sec.gov/News/Speech/Detail/Speech/1370541260300#.VEUn_jYpBCo.
[10] General Instruction C.1.(b) of Form N-1A.
[11] See Derivatives-Related Disclosures by Investment Companies, Letter from Barry D. Miller, Associate Director, Division of Investment Management, U.S. Securities and Exchange Commission, to Karrie McMillan, General Counsel, Investment Company Institute (July 30, 2010) (the "July 2010 Letter"), available at http://www.sec.gov/divisions/investment/guidance/ici073010.pdf.
[12] Disclosure and Compliance Matters for Investment Company Registrants That Invest in Commodity Interests, IM Guidance Update 2013-05 (Aug. 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-05.pdf.
[13] See July 2010 Letter.