U.S. SEC Set to Examine Alternative Mutual Funds

A surge of investment in alternative mutual funds has caught the attention of the U.S. Securities and Exchange Commission, which will launch examinations of fund companies targeting funds’ leverage, liquidity and other concerns, according to an official.

The series of examinations, which will likely begin this summer or fall, will also gauge funds’ compliance with securities industry laws and regulations, said Norm Champ, director of the SEC’s Division of Investment Management, in prepared remarks published by the agency late on Monday.

Among the issues: whether funds are properly determining the value of securities they hold and disclosing risks to investors, Champ originally made the remarks at a seminar for lawyers in New York last week.

Champ’s remarks (available at http://1.usa.gov/1ssp3IS) include significant details about the imminent examinations, known as a “sweep,” which SEC has been discussing since last year.

Alternative mutual funds typically employ investment strategies that imitate those of hedge funds, such as investing in private debt or shorting assets. Traditional mutual funds, in comparison, generally invest in more standard asset classes, such as stocks and bonds, for the long haul.

What is an alternative mutual fund?

According to the SEC, 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).

These investment strategies generally seek to produce positive risk-adjusted returns (or alphas) that are not closely correlated to traditional investments or benchmarks.

These investment strategies differ from those of traditional mutual funds that historically have pursued long-only strategies in traditional asset classes.

The SEC’s review comes as yield-hungry retail investors flock to alternative funds, which held $300 billion in assets as of the end of May, Champ said. Investors poured almost $95 billion into alternative funds in 2013, more than five times the amount they invested in 2012, Champ said.

Alternative funds accounted for just 2.3 percent of the overall mutual fund market at the end of 2013, but investments flowing into those funds represented almost one-third of all investments into the entire industry, Champ said.

The examinations will initially include 15 to 20 fund families, Champ said.

Examiners will home in on several areas, including whether fund managers are complying with the law when they determine the value of assets they hold. That would include derivatives and illiquid assets, such as investments in private start-up companies. Illiquid assets are trickier to value than traditional stocks and bonds, Champ said.

The SEC also expects alternative funds to follow a regulation that generally requires mutual funds to send payments to investors within seven days after they redeem shares.

Champ said funds that invest too heavily in illiquid assets should consider appropriate steps to ensure they can in a timely manner pay investors who redeem their shares, as well as other obligations.

The SEC will also look into the quality of fund governance. For example, a fund’s board of directors must review and approve the fund’s compliance program, Champ said. He said that boards should also steer clear of misleading fund names that suggest protection from losses, among other promises.

In January, the SEC issued a risk alert directing investment advisers to be cautious when they conduct due diligence, or research, alternative investments.

(Reporting by Suzanne Barlyn)