In an anticipated move, the Securities and Exchange Commission is in the process of writing new rules targeting the $50 trillion asset management industry.

Asset Managers

SEC targeting asset managers engaged in sophisticated strategies

The target are likely those mutual funds, hedge fund and private equity investments that engage in sophisticated strategies utilizing derivatives and executing a long / short investment strategy of both buying and selling stocks. A particular focus could be alternative investing mutual funds, who might be forced to limit the use of excessive derivatives leverage.

The review, according to a Wall Street Journal report, is designed to ensure asset managers can withstand economic shocks such as rapidly rising interest rates. If the asset managers were to collapse under the weight of an economic catastrophe, appropriate stress testing would be applied to ensure the fund’s collapse wouldn’t take the world economy with it.

Sharp review of asset managers

The SEC is expected to deliver particularly sharp review of asset managers who are illiquid and exposed to a large number of redemptions at one point.  Also under intense scrutiny will be funds that invest in derivatives to simply magnify returns. One such example would be a fund buying derivatives in stock index futures that could double or triple positive stock market returns in rising stock market environments. Problem with leverage is it can be a two sided sword, magnifying losses past the point of the amount invested. If a fund were long stock index futures and the market crashed, those derivatives could lose all the initial money invested as a margin deposit and more – theoretically an unlimited risk investment.

Many of the rules considered are based on regulations being imposed on the large banks, which has brought out critics. One element the banks are currently fighting hard, that is being opposed by some inside the mutual fund and hedge fund industry, involves living wills. The concept behind a living will is to consider the worst case situation calmly before a crisis strikes. The will determines how positions would be liquidated and the company broken apart under severe market stress.  Making difficult decisions in the middle of a crisis is typically considered the least optimal of solutions. It is assumed under stressful situations a government bailout under favorable terms to the failing company is the most probable path that would be taken. This could be one reason the big banks and large asset managers don’t favor considering how they would handle the worst case situation before it occurs.

Big banks pose different risks than do asset managers

Firms such as Fidelity Investments have strongly opposed the measures, saying the big banks pose different risks than do asset managers. Fidelity is not known to excessively use derivatives or leverage. A fund company more exposed to this type of regulation could be the bond fund Pimco, which, as previously reported, utilizes a sophisticated derivatives strategy in its investment management regime.  As previously reported in VW, Pimco has engaged in what some consider risky Swaps derivatives investments as well as other derivatives positions.