Popular liquid alts funds face regulatory scrutiny

It could be a long summer for the fastest-growing segment of the mutual fund business as regulators zero in on both the marketing of the funds and the investment strategies they employ.

The fastest-growing segment of the mutual fund business is facing new scrutiny this summer from regulators who say they plan to zero in on both the marketing of the funds and the investment strategies they employ.
Sources familiar with the Securities and Exchange Commission’s plan to focus on so-called liquid alternatives, announced in January, said the first phase of “sweep” exams will start this summer, will last about six months and target 25 fund houses managing liquid alts funds.
That’s about 14% of the 185 fund families in the space, who together manage $154 billion in mutual funds, according to research firm Morningstar Inc.
Some alts managers see the sweep in favorable terms.
“It seems to me that this is something where the SEC is going in purely as a sort of advance strike-force,” said Norman E. Mains, managing director for Forward Management, a San Francisco-based hedge fund and alternative mutual fund provider with $5 billion under management. “There may be some isolated instances of issues that the SEC may want to address. Do I know of any specifically? No, I don’t. But it just seems that you’ve had this enormous influx of both new vehicles and existing vehicles that have shifted their strategies to allow them to fall under the umbrella for alternatives and it seems reasonable that some of these — my guess, very few of them — are probably pushing the envelope a bit.”
“Liquid alts” refer to strategies and even managers imported from the exclusive realm of hedge funds and private equity into products like mutual funds, which are regulated very differently under the Investment Company Act Of 1940.
The category includes a broad swath of investment strategies, from global macro to long/short equity to managed futures, with many presented as providing benefits, like decreased risk, by not moving in tandem with the prices of the traditional asset classes, stocks and bonds.
The SEC has said its staff would focus on both the marketing of the funds and the “representations and recommendations made regarding the suitability of such investments.” The commission also announced a plan to evaluate the funds’ practices around financial leverage, liquidity and valuation, as well as the strength of their oversight boards and compliance staff.
A report released this month by PricewaterhouseCoopers said the SEC is working to “shift from reactionary regulation (for which the agency was criticized after the 2008 crisis).”
Now, according to the report, the agency is looking for more “proactive oversight” in an era when savers are plagued by the low income yields on assets affected by an ongoing monetary stimulus program by the U.S. Federal Reserve known as quantitative easing.
“Many retail investors who previously relied on [certificates of deposit, money-market funds, Treasuries and short-duration bond funds] to generate steady income streams may be seeking unfamiliar and riskier products, including liquid alts, in an effort to generate sufficient returns,” according to the report. “Liquid alts are increasingly moving into the mainstream. Successful firms will prepare not only for the upcoming SEC examination sweep, but also for long-term operations under closer SEC supervision.”
In March the examination program’s chief, Andrew Bowden, said the funds are “the bright, shiny object,” adding, “but they’re a sharp object.”
Alternative mutual funds are the fastest growing mutual funds. Investors poured $40.7 billion into the category in 2013, a figure representing more than 40% of the total assets held in the funds the year before, Morningstar estimates. (The figure does not include some nontraditional bond funds.)
That growth comes despite actively managed domestic equity mutual funds, as a group, losing $575 billion from 2007 to 2013. Index funds and ETFs, which are primarily track benchmarks, gained $795 billion, according to the Investment Company Institute, a fund industry trade group.
According to PwC, traditional fund sponsors see alt funds as a potential savior.