On December 11, 2015, the U.S. Securities and Exchange Commission (“SEC”) took steps to more actively regulate how derivative instruments are used by registered investment companies such as mutual funds, exchange-traded funds (“ETFs”), closed-end funds and business development companies. According to its Fact Sheet, a portfolio manager would have to either limit leverage via the use of derivatives to 150 percent of the assets under management or be allowed to increase exposure to 300 percent as long as a risk-based test (“based on value-at-risk”) was satisfied. Other conditions include, but are not limited to, the following:

• Segregation of liquid assets to make a counterparty whole should a fund decide to terminate a derivatives trade “under stressed conditions” or otherwise exit its obligations;
• Board approval of an appropriate risk management strategy and designation of a “derivatives risk manager”; and
•  Heightened disclosure about their use.

Click here to download the 421 page proposed rule.

Even if this oversight document languishes on a shelf, investors are wise to ask about the use of derivatives since the economic risk-return profile of a fund can be dramatically impacted. Here are a few questions:

• Does a fund use derivatives to hedge, speculate or synthesize exposure to a particular asset class, country or currency?
• Is there a risk manager who stays on top of the type of derivatives being used and how counterparty exposure is assessed?
• Has the fund ever run into trouble because of the use of derivatives?
• Who determines trading limits?
• Does the fund have adequate liquidity to meet relevant margins?
• For complex derivatives, how are they valued and by whom?
• How is the economic impact of the use of derivatives reflected on performance statements?
• How is the risk management strategy established and updated and by whom and on what basis?

For institutional investors that have Investment Policy Statements that preclude the use of derivatives, they could be in violation of their own guidelines if they utilize registered funds that trade futures, swaps, options and hybrid derivatives. Certainly increased volatility can whipsaw performance if derivatives are aggressively employed to catch potential upside that never materializes. An institutional investor that allocates to a supposedly even-keeled fund manager could be in for a nasty surprise. Then there is the issue of embedded derivatives that show up in securities such as mortgage-backed bonds.

Although in need of an update of some chapters, Risk Management for Pensions, Endowments and Foundations by Dr. Susan Mangiero offers multiple checklists that can be used by an institutional investor as part of its fund manager due diligence.