The US Securities and Exchange Commission (SEC) launched a broad “examination” of alternative investment mutual funds, according to a report in the Wall Street Journal.

SEC filings SEC Enforcement

SEC is seeking to determine how alternative funds operate

Not to be confused with an “investigation,” the SEC is seeking to determine how these funds operate rather than deliver enforcement, the Journal says, quoting sources familiar with the matter.

The move comes as the popularity of alternative investments has reached an all time high as investment advisors look to diversify from portfolios entirely dependent on the positive performance of the stock market.

The report noted regulators are targeting fund liquidity, leverage usage – a significant issue those close to derivatives investments typically closely follow — and the degree of oversight, or lack thereof, provided by the funds’ boards. In some cases fund boards are knowledgeable regarding the alternative investing trading strategy and risk, in other cases the fund’s core strategy is not totally understood by the board.

Looming US debt crisis

With acknowledged issues with the withdrawal of Federal Reserve stimulus, a looming US debt crisis and mounting international concerns, some funds are expanding into investments with lower correlation to the performance of the stock market. This growth is evidenced through AQR Capital Management LLC, a leading managed futures trend follower and algorithmic pioneer in the space.  Founded by former Goldman Sachs trader Cliff Asness, when the fund launched its first such mutual fund in 2009, it had $20 billion under management. Now “Mr. Momentum,” as he is referred to, manages $113 billion in a combination of traditional hedge fund, mutual fund and account structures.

The academic exploration by the SEC was first signaled to the markets earlier this spring, but at the time the word “investigation” was used.

On April 30 of this year, ValueWalk reported the SEC could investigate alternative investment funds and the fees they charge and, critics say, sometimes don’t disclose.

In the fund arena and area of interest could be the “undisclosed fees and conflicts of interest,” a term White referred to in a speech. The issue came to light in reporting by Bloomberg’s David Evans in an article on fee disclosure in managed futures mutual funds.  In the article Evans, a former CFTC enforcement lawyer turned Bloomberg columnist, reported that these algorithmic trading funds would charge fees as high as 9% without clear disclosure to the investor.

SEC fee disclosure for managed futures funds

When managed futures funds started offering the uncorrelated investment through securities brokerage firms for the first time, the fee and performance disclosure standards conflicted and the SEC prevailed over the CFTC on the issue.  The managed futures direct account mandated that performance was disclosed after all fees and expenses, net net, and that all account activity was transparent to the client.  Fee disclosure and the impact on performance followed a strict formula.  The SEC fee disclosure was extensive but legally dense for the average investor.  Critics have charged the complex disclosure was intentionally opaque so as to mask hidden fees, an issue first exposed on 60 Minutes but never addressed until now by White.

It is unclear if the performance reporting net of all fees, with clear tables showing fees, might be considered.  Another area that could be under consideration is to categorize the funds based on their strategy type so that correlations might be understood during times of crisis.  The SEC is also said to have technology that now tracks each trade in an effort that could be used to curb algorithmic manipulation of markets through high frequency trading strategies considered manipulative.