By Matt Halperin

In November 2019, the SEC again proposed a new rule covering the use of derivatives by mutual funds – including ETFs and closed-end funds. The SEC previously proposed a rule in 2015 to which the industry provided many comments. In early 2018, the LJM Preservation and Growth Fund, a mutual fund that engaged in options strategies, blew up in a few days-it lost 82% of its value in two days. This fund failure caused the SEC to re-engage in derivative rulemaking. The SEC did reach out to the fund industry as it was redrafting.[1]

Law firm summaries can be found here, here, here and here.

The new rule requires specific actions on the part of Board members and fund companies. The fund company would need to adapt various policies and procedures and designate a derivatives risk manager, independent of the investment function to oversee the program. The manager would be responsible for stress testing and back-testing, as well as monitoring the fund’s use of leverage relative to a VAR test. The risk manager would need to be approved by the Board and the Board will get periodic reporting,

The SEC did carve out firms using less than 10% in derivatives and those solely engaged in currency hedging. Boards should still ask for stress testing-our example below provides a good example.

The question I ask clients-“What reporting on derivatives do they get now? Do they think it is adequate?”  What do I think Boards should be asking for with or without a derivative rule?

1.      Why is the manager using derivatives in the fund? “Hedging” does not cut it anymore as a reason.-that worked 25 years ago. Today, you should hear- our TCA work shows it is cheaper or some other well-articulated reason. They should compare the derivatives strategy  to what they would have to trade if they did not use the derivative.

2.      Are the derivative positions so small that they are a distraction to the manager, the firm, and the Board? If the position doubles in value, will it have moved the performance needle? Are the positions small as the manager is experimenting? PMs should not be learning how to use derivatives with client money.

3.      When asked what keeps me up at night as a risk manager, it is always the margin call. Every crisis I know is at heart a margin call. Futures require cash margin flows each day. Will the fund have the cash to meet the margin call? What securities does it expect to sell to pay the margin- are they counting on repo?  What if there is a market lock up? Look at September 2019 – in the US, you could not easily repo a security. Markets seize upped. You need to run simulations of what will happen to the derivatives and what your sources of cash will be. What happens if you get a margin call and a large redemption?

This stress testing is a key part of  what the SEC is looking for in its rule, and it is a basic risk 101 task. The Board should see reports or a summary of reports that show how the fund will handle cash margin calls.

 Let me give you a simple example:

A fund has $100 million. It converts to sterling to buy BP stock. For simplicity, on the day of the trade dollar/sterling is 1:1. So the fund has 100 million in BP stock denominated in sterling. 

• The manager decides to hedge by selling sterling forward for dollars. He agrees to buy dollars and sell sterling in 90days, and they set the rate today at 1:1.

• In 90 days, the fund will need to deliver to the bank with 100million in sterling or, more likely, settle the trade for the change in value. If sterling is has appreciated by 10%, the fund is going to need 10% of [100mm] to settle up. Where is it going to come from? All the cash is in the stock.  Sell some stock, idle cash? (The price change has already hit the NAV over the last 90 days. )

• What happens if the stock loses half its value a week after the trade is put on and sterling appreciates 10? The fund is now over hedged by 50% and lost 10% more on the 50%. The forward hedge needs to be reduced. The fund took a loss on a ‘hedge.’ The fund needs to have policies on truing up hedges- not waiting 90 days to true-up. 

This is where stress testing, and discussing those stress tests with the Board can make a difference in that the Board and the Investment manager can have a better conversation. There are many more nuances that the Board should see that management considered.

Litmus test: If the manager says they only own ADRs so they have no currency risk, call us fast! They need an education.

 Reach out to learn how we can help you.  

    [1] The SEC is required to disclose all meetings with the industry. You can see who met with the SEC on this here.