The Securities and Exchange Commission (SEC) is reviewing “hedge fund mutual funds” being offered to average investors, evaluating leverage risk in these “uncorrelated” investments.

SEC

Mutual funds were designed as a method to enable investors to obtain stock diversification through a small investment, typically a positive risk management strategy.  Investments in hedge funds, normally a preserve for the technically defined “accredited” well-to-do investor, were recently made available through common mutual funds with the notion they could help further diversify investors from potential economic storms.

The problem with these mutual funds is they utilize often opaque strategies with managers sometimes accustomed to transferring their sometimes aggressive trading and revenue generation strategies into a mutual fund format.  The SEC is testing 25 of the trading strategies to determine if they are utilizing too much leverage.  This approach is not uncommon as watching margin-to-equity levels in quantitative hedge fund investments is a common strategy among sophisticated professional investors.  It is these quantitative investments along with non-traditional bond funds that are known to reach for yield in what might be considered risky sovereign and corporate debt.

SEC: Review of risk and fee disclosure?

Fee and risk disclosure in many of these alternative investment mutual funds is an issue with a little-known deeper history.

The fee issue in particular got red hot last October when Bloomberg’s David Evans wrote an article showing how certain alternative investment mutual funds gobbled up close to 8% in fees and expenses while leaving investors holding losers.

What is not commonly known is that the SEC and CFTC had engaged in a behind the scenes wrestling match over the alternative mutual fund fee disclosure issue.  The issue did get slight mention in some press reports, but the impact of the regulatory fight has yet to be recognized.

Fee and risk disclosures opaque in their complexity

At issue was said to be a simple versus complex mutual fund disclosure table for managed futures mutual funds.  The fight lasted for a year when ultimately the CFTC and its backing of simple fee and return calculations lost to the more complex – some might say opaque due to the complexity – fee, risk and returns disclosure. The CFTC said they would issue a report on the issue and commissioners were said to be aware a fight took place over the disclosure tables, yet no report has yet to surface.  If a report does surface, the disagreement with the SEC may only receive oblique reference, if any.

SEC and CFTC staffers rarely get along behind the scenes, as fights with the older brother aren’t always fair. More often than not the CFTC is put into a submissive status at the request of higher levels. This is said to have happened on the managed futures mutual fund fee disclosure as well as MF Global. This has been the case through Republican and Democratic administrations that dates back to the late 1990s when Brooksley Born was unceremoniously removed as CFTC chairwoman.

So the SEC is reviewing the alternative investment mutual fund, we just don’t know exactly how deep that review will dive.