The use of derivatives in mutual fund portfolios has risen substantially in recent years as portfolio managers have found ways to generate additional income and hedge their portfolios using these instruments. But in some cases they have been used inappropriately, and the Securities and Exchange Commission (SEC) has proposed a set of rules that will limit the use of derivatives by fund managers. But some critics maintain that the rules need to be restructured so that they will not impede the fund managers’ ability to properly diversify their portfolios.

What They Are

Derivatives by definition are securities that allow investors to hedge their portfolios and also profit from market movements without having to purchase shares of the underlying security or benchmark index. These versatile instruments can provide quick and substantial profits, or losses, for investors who buy them with a relatively small capital outlay and can also provide a steady stream of income for those who sell them. And they can also be structured in groups to guarantee certain investment objectives, such as limiting the amount of profit or loss in an underlying holding. They can be useful tools for portfolio managers who are looking to generate additional income in a tepid market or protect their portfolios from substantial losses. (For more, see: Derivatives - Purposes and Benefits of Derivatives.)

SEC Proposal

The use of derivatives resulted in some funds becoming excessively leveraged, which resulted in large losses for certain types of funds during the 2008 subprime mortgage meltdown. This has led to the SEC’S proposal to curb the use of these instruments by open and closed-end mutual funds as well as exchange-traded funds (ETFs) and business development companies. These new rules are broken down into three principal components:

  1. Exposure Limits: The first part of the new rules will place limitations on the amount of exposure that funds can take on in their portfolios. In a general sense, the mathematical limit of a fund’s exposure to derivatives would be equal to 150% of the fund’s total assets. Funds that are able to satisfy a risk-based test indicating that the use of derivatives will lower the fund’s overall risk will be permitted twice that amount of exposure (300%). (For more, see: 5 Equity Derivatives and How They Work.)
  2. Cash on Hand: Funds that employ the use of derivatives in their trading will be required to have a certain amount of cash or cash equivalents on hand to cover their transactions. The amount must be large enough to cover the amount needed for the fund to mark all of its derivative obligations to market, plus an additional amount to cover the fund’s possible future expenses and obligations.
  3. Risk Management: Funds that employ derivatives in any type of aggressive manner will be required to create and implement a comprehensive risk management strategy. An exception will be made for funds that only employ derivatives in a limited and conservative manner. (For more, see: Are Derivatives Safe for Retail Investors?)

    Industry Feedback

    Although the SEC’s proposal is designed to help lower the overall level of systemic risk being taken by fund managers across the board, some industry observers feel that it will ultimately end up hurting investors by limiting fund strategies and investment choices. The Coalition for Responsible Asset Management just released a study that indicates that the SEC’s proposal would fail to capture the specific risks being taken by the fund managers in an accurate manner.

    The Bottom Line

    Although the comment period for the SEC’s proposal is now closed, some experts fear that the proposal does not adequately take into account the “good” uses of derivatives from the “bad.” However, most critics are still on board with the general idea of curbing the use of derivatives by fund managers to some extent. (For more, see: Alternative Investors: More Transparency vs. Less Regulation.)