Regulators get tougher on liquid alternatives

Increased regulatory scrutiny of liquid alternative mutual funds or ’40 Act hedge funds could have a major impact on the asset class.

The Securities and Exchange Commission (SEC) is putting pressure on liquid alternatives amid concerns around their liquidity profile, systemic risk and suitability for retail investors. The SEC – through Rule 18f-4 – is looking to restrict the use of derivatives for leverage purposes by registered investment companies such as mutual funds, closed-end funds and exchange traded funds (ETFs).

The SEC, which concedes its approach may be too blunt in its own right, is proposing a hard exposure limit of 150% of fund net assets based on the notional aggregate amount of derivatives. The proposed rules also contain an obligation to segregate liquid assets such as cash, and this will make it tougher for RICs including certain alternative mutual funds to utilise derivatives.

Analysis by PricewaterhouseCoopers (PwC) said the rules would disproportionately impact heavy derivatives-users such as managed futures and commodity funds. “The impact of the SEC’s proposed rules on derivative exposures could have negative ramifications for certain strategies,” said Paul Miller, partner at Seward & Kissel in Washington DC.

Liquid alternatives have been subject to examinations by the SEC. The SEC announced in September 2015 that it would introduce provisions restricting liquid alternative managers from holding more than 15% of their assets in illiquid instruments. This instruction came as the SEC expressed concerns that market volatility or a severe credit event could force liquid alternative managers to sell assets quickly to meet their redemption terms. The regulator argued any rapid fire sale of assets would hurt investors and potentially upset liquidity.

The failure of Third Avenue’s junk bond fund in December 2015 represented the biggest mutual fund failure since 2008 and has prompted concern among regulators. Redemptions from the fund have been suspended while positions are unwound. The extent of the losses are not yet known. “In light of the developments at the Third Avenue fund, the SEC staff is conducting reviews of certain mutual funds and their liquidity profiles. Regulators want to understand the extent of any potential liquidity mismatches – such as portfolio liquidity versus fund redemption liquidity – in mutual funds,” said Miller.

Furthermore, the SEC has proposed rules that would require mutual funds including liquid alternative managers to implement liquidity risk management programs. Funds would be required to classify portfolio positions into one of six liquidity buckets. “The liquidity buckets are based on the number of days in which the fund position could be converted to cash at a price that does not materially affect the value of the asset immediately prior to sale. This assessment would be subjective and the details have not really been fleshed out yet for many types of assets held in fund portfolios,” said Miller. The SEC proposals would allow mutual funds, including liquid alternatives funds, to utilise swing pricing.

The enhanced scrutiny also came as the Financial Stability Oversight Council (FSOC), the governmental body tasked with monitoring systemic risk in US capital markets under Dodd-Frank, said it would not classify asset managers as systemically important financial institutions (SIFIs). “There certainly seems to be a correlation between the FSOC’s activities and concerns about asset managers and the SEC’s rulemaking efforts for registered funds and advisers. The SEC is seeking to address some of the concerns raised,” commented Miller.

Interest in liquid alternative products has remained strong. A paper published by the Alternative Investment Management Association (AIMA), the hedge fund industry group in conjunction with PwC said 87% of liquid alternative managers surveyed had experienced an increase in Assets under Management (AuM). The survey added nearly a third of US firms were planning to launch a liquid alternatives vehicle. Barclays predicted liquid alternatives, which presently manage around $300 billion, could control between $650 billion and $950 billion by 2018.

Many hedge funds have launched such products to diversify their investor base away from institutions and towards defined contribution pension schemes (DCs), individual retirement accounts, annuity reserves, broker dealers and registered investment advisers (RIAs). A study by Barclays estimates this investor grouping manages around $19 trillion in assets. The DC plan market is alone estimated to be worth $5.1 trillion, according to SEI. Nonetheless, these investors ae notoriously conservative and reluctant to allocate to asset classes outside of their comfort zone. However, the market volatility and low/or negative yields on bonds is prompting a gradual re-think.

Experts question whether these inflows into liquid alternatives are slowing. “2013 and 2014 were better years for new liquid alternative start-ups and inflows, both of which slowed down a bit in 2015. There is always a possibility that there could be some M&A activity in the liquid alternatives space if there is no pick up or withdrawals,” said Miller.

It is critical that fund managers recognise there are a number of obligations and requirements around running a 40’ Act Fund. Some believe hedge funds – which traditionally have a fairly unconstrained approach towards investing – may be hamstrung by the leverage and investment restrictions imposed upon them in a 40’ Act structure. This is a problem that has certainly affected some alternative UCITS in Europe. Others point out the absence of a performance fee and low management fees, corporate governance obligations and third party custody requirements make running a ’40 Act hedge fund uneconomical. With the growing regulatory interest, the enthusiasm among some hedge fund or private equity managers to launch regulated products may wane.