The (Mutual Fund) Empire Strikes Back

We’ve waited a while to put out a post on the new rules handed down to the mutual fund industry in February regarding their trading of futures contracts within a security product.

The rub of the matter is this: Futures are complex, and are not suitable for all investors – leading to requirements that those selling such investments to investors be registered with the CFTC and NFA, that disclosures about the unique risks are made, and that investors sign off that they understand all such risks. This is how the futures industry works, with investors filling out dozens of pages of forms in order to be able to access futures markets.

Problem is, mutual funds trading futures aren’t weren’t required to make all of these disclosures. Why not? Because of waivers given to investment companies back in 2003 on the premise that their futures trading was mostly incidental to their main business, and that they were not marketing themselves as commodity futures funds. Fast forward a few years to the post-2008 crisis period when managed futures were in high demand, and firms wanting to do managed futures mutual funds were able to take advantage of this loophole. Suddenly, investors wanting to do a managed futures mutual fund could just click on the fund on E-Trade or the like and suddenly be invested in a portfolio of sophisticated managed futures investments which would otherwise require millions of dollars and hundreds of pages of disclosures to get involved with. This has always rubbed us the wrong way – we’re a firm that introduces clients to such managers, and we have to follow the rules and have our clients go through the hundreds of pages of forms and disclosure in order to invest. Why do our sophisticated clients have to do it, but less sophisticated clients do not?

And we weren’t the only ones who saw this as a problem – the NFA caught wind of it and sent a letter to the CFTC in August of 2010 requesting that the CFTC restore operating restrictions on registered investment companies doing futures trading.

That letter then sat at the CFTC for nearly 18 months, until this February when the CFTC announced it was indeed rolling back the rule exclusion allowing mutual funds that invest in futures to bypass registration. From Pensions and Investments (emphasis ours):

The Commodity Futures Trading Commission said in February that it will put the kibosh on a rule exclusion that allows mutual funds that invest in commodities through futures contracts and other derivatives to bypass having to register with it as a commodities pool operator…

The change to the so-called Rule 4.5 exclusion, which will take effect Jan. 1, also will affect managed-futures mutual funds.

The rule change also will require fund companies to bolster disclosures related [to] funds that invest in commodities and managed futures. The CFTC generally requires more disclosure than the SEC.

What does this mean? The bulk of these funds will likely need to register with the NFA and CFTC as commodity pool operators, which could require them to do things like create and submit a disclosure document which reports the performance of similar products they’ve offered (potentially highlighting their lack of experience in fund management) and presents a break-even analysis including the fees of the individual managers doing trading for the fund. It could also subject them to the NFA’s promotional material standards and review (have fun with that one).

Oh, and the fees could go higher. The article continues:

“It’s going to immediately impact the profitability of the funds,” said John McGuire, a partner in the investment management and securities industry practice at Morgan Lewis & Bockius LLP. “Over time, firms are going to try to get profitability back to where it was, and they’re probably going to have to raise fees to do that.”

Perhaps the funniest part of this nonsense is the way in which those with skin in the game are reacting. They’re calling it a regulatory “land grab” where investors are the ones who get hurt. Wait a second – they’re telling us that requiring companies to actually educate the investor – and provide the disclosures that all normal futures investors already get – will hurt the investor? Yet that is exactly their argument. And they’re taking it to the courts. Bloomberg reports:

The U.S. Commodity Futures Trading Commission was sued by two business groups seeking to overturn a rule requiring mutual funds with commodities investments to register with the agency.

The CFTC didn’t properly assess the costs and benefits when it imposed the regulation in a 4-1 vote in February, the U.S. Chamber of Commerce and the Investment Company Institute argue in a lawsuit filed today in federal court in Washington. The measure is unnecessary, they said, because mutual funds are already overseen by the Securities and Exchange Commission.

The rule, “if allowed to stand, will impose enormous costs and burdens,” ICI President Paul Schott Stevens said in a call with reporters. “Ultimately those costs will come out of shareholders’ pockets,” said Stevens, whose Washington-based trade group lobbies on behalf of mutual funds.

What’s completely amusing is that they think the registration is unnecessary because the funds are already regulated by the SEC. What they conveniently leave out is that the SEC (or Securities and Exchange Commission) oversees securities, and has written regulation particular to the sale of securities – and has no such regulations in place for the sale of futures. While the mutual fund wrapper is surely a security, everything else underneath is futures trading through and through – meaning well within the jurisdiction of the CFTC. It’s like putting a piece of chicken in a hamburger bun and saying this is sold as beef; ignore the chicken.

And costs? Let’s be real. These companies, who developed their mutual funds in a regulatory no-man’s land between the CFTC and SEC, while fully aware of the NFA’s letter to the CFTC and heated debate that’s been going on about closing the loophole since it was first granted a tentative stay of execution in 2003, are now complaining that they’re about to lose a great deal of money. In our minds, they gambled on the regulatory landscape, and they lost. They created a product that is clearly advertised as giving access to commodity futures and puts potentially ill-suited investors into a very sophisticated investment space, all while skating on very thin regulatory ice. Now we’re supposed to feel bad for them?

Nobody knows how this will all shake out. This lawsuit is likely to take some of the sting out of the new rules, with settlements and compromise likely as they finalize the harmonization of SEC and CFTC rules. But in the end, we’re hopeful common sense wins the day – if you’re selling a commodity futures product – it sure seems like you ought to follow the rules for selling it.