The Securities and Exchange Commission has issued a new set of updated and modernized regulations for the mutual fund industry that includes some provisions designed to reduce the risk to the overall markets if a glut of investors all decide to sell their shares at once, The Wall Street Journal reports. But the mutual fund companies were also able to convince the SEC to include some provisions that make the new rules more flexible. The rules have come in the wake of changes in the mutual fund industry, as funds have now moved beyond the mere pooling of stocks and bonds into riskier and more complex categories such as alternative and illiquid investments and leveraged funds.

Clamping Down      

Economists from the Federal Reserve Bank of New York and the International Monetary Fund have warned the SEC that the mutual fund industry can suffer destabilization if there is a substantial run of sales by investors within a short period of time, as this could force many funds to liquidate securities at depressed prices instead of their true market value in order to meet shareholder demand. The new rules are designed to prevent this possibility from occurring. (For more, see: Understanding Liquidity Risk.)

But many fund managers have disputed the new regulations, saying that the majority of their investors are long-term investors who will keep their money invested regardless of current market conditions. They feel that the new rules could unintentionally hurt some investors and reduce their returns.

The original proposal that was drafted a year ago by the SEC would require mutual funds to maintain cash reserves that could be liquidated within a three-day period in order to guard against a mass exodus by investors. The amount that must be set aside for this purpose would be higher for mutual funds that invest in less liquid securities, such as emerging markets and bank loan funds. Many funds criticized this proposal, saying that the three-day rule would impede substantially on their investment strategies. Federated Investors Inc. responded that it would not be able to purchase high-yielding securities under the new rule because it could cause their cash reserves to drop below the minimum required amount.

Revised Version

The SEC has therefore released a revised version of its proposal that will give mutual funds some leeway in this matter by allowing them to set the three-day rule as a goal within the scope of their investment strategies. As long as a mutual fund has a policy to meet the three-day rule, then it can pursue investment strategies that may conflict with the rule for short periods of time. (For more, see: How New SEC Rule Would Impact Alternative Mutual Funds.)

The original proposal drafted by the SEC also would have required fund managers to estimate the amount of time that it would take to liquidate each of the securities in the fund at any given time. The fund companies were quick to respond that it would be impossible to estimate this, because the time that it takes to sell a security will vary substantially according to market conditions.

Federated Investors wrote earlier this year that: “Federated believes that the components of the proposed rule requiring the categorization of individual security positions are onerous, illogical, and may, if executed, be misleading to shareholders.” The revised version of the SEC’s proposal therefore also scaled back this provision, so that fund managers are only required to estimate the time that it would take to liquidate a given asset class, such as government bonds or small-cap stocks.

The Bottom Line

There have never been regulations of this sort implemented in the mutual fund industry before. The SEC’s proposal is designed to prevent a mass exodus of investors in the event of a major market downturn, such as the one in 2008. Advisors may need to wait for the next market downturn to see how these rules might play out. (For more, see: Are Hedged Mutual Funds for You?)

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