If it looks like a duck, but honks like a goose, is it a duck or is it a goose?
As far as the US Securities and Exchange Commission is concerned, the duck can honk all it wants, it still has to live by duck rules. The regulatory agency is making certain that mutual funds that act like hedge funds follow the same straight and narrow road as their traditional mutual fund brethren. regardless of the difference in investment strategy. To make sure of that, the SEC’s Office of Compliance, Inspections and Examinations plans sweep exams on about twenty-five funds with hedge fund-like strategies by year-end.
While so called “alternative liquids” may comprise only a small fraction — less than three percent — of the entire mutual fund community, the US market watchdog’s recent announcement that it will pay far closer attention to how they operate should spur managers of those investment vehicles to take a hard look at their operations, warn legal and valuation experts. More specifically, the SEC will be looking at their policies for accuracy in valuations, liquidity and leverage provisions to see if they match mutual fund requirements.
“Each of the three elements have separately been top of the SEC’s radar for several years, are now converging in the alternative liquid space and in a very intense way,” says Andrew Cross, a partner in the Washington DC office of legal firm Perkins Coie. The reason: as was the case with hedge funds, a lot more money is pouring into the asset category and the SEC needs to ensure that investors are protected. In 2013, investors gave the alternative liquid class almost US$95 billion in new monies — more than five times what they did in 2012, the SEC estimates. That growth rate far exceeds either the traditional mutual or hedge fund sectors.
Investment Tweaks
Fans of alternative liquids say the potential benefit of a hedge-fund like approach are clear in the current investment environment, where returns are limited. But the new hedge-fund like mutual funds also come with the higher risk of financial losses. They can imitate hedge fund tactics, such as buying private debt or entering into over-the-counter derivative contracts. They can also rely on long/short investment strategies which means they gamble on some assets rising in value and some declining in value.
By contrast, many traditional mutual funds can be pretty dull investment vehicles: they rely on standard equity and bonds and invest for the long haul, naturally adapting to regulatory limitations designed to protect the interest of their investors. The SEC wants those boundaries to hold firm, even now that the masses are being exposed to hedge fund strategies. “The exams will produce valuable insight into how alternative investment funds attempt to generate yield and how much risk they undertake, in addition to how well boards are carrying out their oversight duties,” said Norm Champ, chief of the SEC’s Investment Management Division, in a speech in early July.
At the same time that some mutual funds are offering alternative liquids in response to investor demands for higher alpha, some hedge funds are entering the mutual fund space to attract additional capital they couldn’t get otherwise, because of stricter entrance requirements for hedge fund investors. Hedge funds are typically reserved for accredited investors, which the SEC defines as an individual whose annual income tops US$200,000 or whose net worth exceeds US$1 million, including the value of the prime residence. “Either way, the Investment Company Act of 1940 applies to any mutual fund fund regardless of whether its investment manager follows a traditional or liquid alt strategy, as evidenced by the SEC’s announcement,” says Cross.
While mutual fund managers and hedge fund managers will have the same legal requirements, they will face the music in different ways. “Mutual fund managers will need to get up to speed on new trading strategies and monitor valuations and leverage more closely while hedge fund me anagers will need to familiarize themselves with the regulatory limitations that apply to mutual fund investments,” explains Jay Baris, chairman of the investment management practice for Morrison & Foerster in New York.
Under the rules of the Investment Company Act, mutual funds must strike a net asset value daily and investors must be allowed to redeem their shares each business day and receive payment within seven days of their request. That means that the fund manager must invest most of the fund’s assets in assets which can be liquidated quickly. Last but not least, the mutual fund manager cannot rely on too much leverage — or owing too much money– as could be the case with investing in too many over-the-counter derivative contracts.
Not so with hedge funds, whose investment strategies and redemption gates are not regulated by the SEC. They are allowed to impose timetables in which shares must be held before they can be redeemed– anywhere from several months to several years. “Hedge fund managers wanting to enter the alternative liquid market will likely feel like a free bird now stuck in a cage, but stand to benefit from another source of management fees,” notes Baris.
Valuation Challenge
Because a mutual fund is required to strike a daily net asset value, it needs to price all the assets in its portfolio each day. For assets that are exchange-traded it’s a breeze. They just check out the last price listed on the exchange in which the equity is traded. However, they can’t do so when it comes to non-exchange traded assets — typically fixed-income securities and over-the-counter derivatives.
Hence, they will have to do a mark-to-market valuation to come up with a so-called fair value, according to Nicholas Tsafos, a partner at global accounting firm Eisner Amper in New York. That is the price at which the holding could be sold, and valution will rely on a combination of art and science–objective market data and other inputs and subjective pricing models and methodologies.
Although the legal liability for overseeing a mutual fund’s valuation rests with its manager’s board of directors, that board will designate the responsibility for actually conducting all the valuations on the mutual fund manager. The mutual fund manager might take on managing the new alternative alt on its own, but could decide to share the work with a subadvisor — aka a hedge fund manager — who may handle trading responsibilities which are beyond the mutual fund manager’s expertise. In doing so, the hedge fund manager may also need to value the non-exchange traded securities under its umbrella.
However, that doesn’t mean the mutual fund manager will have nothing to do. Quite the contrary. “It will have to verify that the valuation policies of the subadvisor meet the criteria of the fund’s board of directors before hiring the subadvisor. And once hired, will need to continually monitor its procedures,” says Tsafos. “The approach must be proactive, rather than reactive.”
That monitoring doesn’t necessarily mean talking on the phone or even reporting on the value of the non-exchange traded assets daily, he explains. However, it does mean establishing a means for the mutual fund manager to know when the price on the assets managed by the subadvisor must be changed; the reason for the change — most likely a change in market conditions — and how it will impact the net asset value of the overall alternative liquid fund.
“Managers of alternative mutual funds can’t afford to be surprised,” says Espen Robak, director of Pluris Valuation Advisors LLC, a New York-based valuation specialist. It’s important that they understand that market values can change quickly, even for illiquid securities. “If market movements are missed, because certain assets haven’t traded in a while, then that may necessitate a sudden mark-down later.”
Bottom line: fund managers need to be vigilant so their investors aren’t blindsided and start redeeming their shares en masse. When valuing illiquid assets, advises Robak, managers of hedge funds and alternative liquids should typically obtain valuations from three different external specialists and throw out the high and low valuations, instead relying on the mid-ranged one, with the presumption it will be the most objective. “Any outliers — or prices which deviate too far from the norm — should be eliminated and any discrepancies reconciled,” he says.
Although managers of alternative liquids face additional work pricing any non-exchange traded asset, some are more problematic than others. Case in point: a pre-IPO share. “Its value might not change that often before the IPO, but the difference between what the fund manager would price the shares before the initial public offering and the actual price when the company goes public could be dramatic and have a serious impact on the ultimate net asset value which must be struck daily,” says David Larsen, managing director at valuation service provider Duff and Phelps in San Francisco.
Two more examples, according to Amy Poster, director of risk and regulatory advisory services for C&A Consulting in New York: leveraged loans and long-dated options. “In the case of leveraged loans that trade by appointment, bond or loan credit default swap (CDS) prices can usually serve as a proxy. However, you have to account for basis risk because loans trade tighter than the CDS,” she explains. When it comes to long-dated options, volatility is a critical input in pricing and “vols” for maturities longer than two years are often unavailable. Therefore, a fund manager can either use implied or historical volatility. In either case, the figure may be just an estimate.
Other than making the best effort to value correctly and relying on third-party experts, documenting the methodology used and disclosing it to investors is advisable, says Larsen. Large mutual fund complexes can rely on their valuation committees, explains Poster, but smaller ones wanting to enter the liquid alt space would be well served to bring a risk manager working with controllers into the decision-making process.
Liquidity Risk
Valuations and liquidity are closely intertwined. Because mutual funds are required to redeem their shares within seven days of an investor’s request they cannot invest in too many assets which are illiquid — or would take a longer time to sell. They do have some breathing room in what they can buy, but must make a decision about whether or not an asset is liquid enough to purchase or whether it risks becoming more illiquid and must be sold. No more than 15 percent of the value of the fund can be invested in so-called illiquid assets.
“The investment management unit headed up by the portfolio manager will need to continually monitor liquidity of all the assets and incorporate the extent of liquidity into the price of the asset,” explains Robak. “The more liquid the asset on the scale of semi-liquidity, the higher the price. Less liquid assets should be priced lower, because of their lack of marketability.”
Not only does the SEC want to ensure the manager of the liquid alternative correctly monitors valuations and liquidity but also the amount of leverage. As a rule of thumb, the more over-the-counter derivatives in a portfolio, the higher the amount of leverage, because more payments will have to be made to counterparties. “Managers of alternative liquid funds will need to ensure they don’t breach the SEC’s limitations on leverage and ensure they set aside enough liquid assets to cover leverage obligations,” explains Baris. A fund manager can segregate assets by having a custodian mark liquid securities on the fund’s books to be used only to cover potential obligations resulting from leveraged investments.
Regardless of how diligently a liquid alt manager tries to adapt to SEC guidelines, human error and lapses in oversight can and will happen. The best safeguard to avoid costly mistakes is to have a robust governance and risk management framework to meet valuation and liquidity compliance controls, says Poster. It is also important to invest in IT infrastructure to manage leverage risk and enable accurate leverage reporting across investment strategies.
“Alt fund managers need to establish policies and procedures to address and immediately rectify compliance breaches,” says Poster. One way: rely on a combination of technology and solid oversight. Trading breaches, for example, are usually flagged by the compliance department. She recommends that, in addition, controllers and risk managers monitor daily concentration, position and trading limit reports.”These control points should not hesitate to provide constructive challenge to portfolio or trading desk managers when trading limits are violated,” says Poster.
Taking all the right steps will certainly help keep the SEC happy but there is one final validation which can be done before the SEC knocks on the door. “Check all the procedures in advance, test to make certain they work, and conduct a mock exam to make sure you can answer the SEC’s questions,” says Baris.
If it looks like a duck, but honks like a goose, is it a duck or is it a goose?
As far as the US Securities and Exchange Commission is concerned, the duck can honk all it wants, it still has to live by duck rules. The regulatory agency is making certain that mutual funds that act like hedge funds follow the same straight and narrow road as their traditional mutual fund brethren. regardless of the difference in investment strategy. To make sure of that, the SEC’s Office of Compliance, Inspections and Examinations plans sweep exams on about twenty-five funds with hedge fund-like strategies by year-end.
While so called “alternative liquids” may comprise only a small fraction — less than three percent — of the entire mutual fund community, the US market watchdog’s recent announcement that it will pay far closer attention to how they operate should spur managers of those investment vehicles to take a hard look at their operations, warn legal and valuation experts. More specifically, the SEC will be looking at their policies for accuracy in valuations, liquidity and leverage provisions to see if they match mutual fund requirements.
“Each of the three elements have separately been top of the SEC’s radar for several years, are now converging in the alternative liquid space and in a very intense way,” says Andrew Cross, a partner in the Washington DC office of legal firm Perkins Coie. The reason: as was the case with hedge funds, a lot more money is pouring into the asset category and the SEC needs to ensure that investors are protected. In 2013, investors gave the alternative liquid class almost US$95 billion in new monies — more than five times what they did in 2012, the SEC estimates. That growth rate far exceeds either the traditional mutual or hedge fund sectors.
Investment Tweaks
Fans of alternative liquids say the potential benefit of a hedge-fund like approach are clear in the current investment environment, where returns are limited. But the new hedge-fund like mutual funds also come with the higher risk of financial losses. They can imitate hedge fund tactics, such as buying private debt or entering into over-the-counter derivative contracts. They can also rely on long/short investment strategies which means they gamble on some assets rising in value and some declining in value.
By contrast, many traditional mutual funds can be pretty dull investment vehicles: they rely on standard equity and bonds and invest for the long haul, naturally adapting to regulatory limitations designed to protect the interest of their investors. The SEC wants those boundaries to hold firm, even now that the masses are being exposed to hedge fund strategies. “The exams will produce valuable insight into how alternative investment funds attempt to generate yield and how much risk they undertake, in addition to how well boards are carrying out their oversight duties,” said Norm Champ, chief of the SEC’s Investment Management Division, in a speech in early July.
At the same time that some mutual funds are offering alternative liquids in response to investor demands for higher alpha, some hedge funds are entering the mutual fund space to attract additional capital they couldn’t get otherwise, because of stricter entrance requirements for hedge fund investors. Hedge funds are typically reserved for accredited investors, which the SEC defines as an individual whose annual income tops US$200,000 or whose net worth exceeds US$1 million, including the value of the prime residence. “Either way, the Investment Company Act of 1940 applies to any mutual fund fund regardless of whether its investment manager follows a traditional or liquid alt strategy, as evidenced by the SEC’s announcement,” says Cross.
While mutual fund managers and hedge fund managers will have the same legal requirements, they will face the music in different ways. “Mutual fund managers will need to get up to speed on new trading strategies and monitor valuations and leverage more closely while hedge fund me anagers will need to familiarize themselves with the regulatory limitations that apply to mutual fund investments,” explains Jay Baris, chairman of the investment management practice for Morrison & Foerster in New York.
Under the rules of the Investment Company Act, mutual funds must strike a net asset value daily and investors must be allowed to redeem their shares each business day and receive payment within seven days of their request. That means that the fund manager must invest most of the fund’s assets in assets which can be liquidated quickly. Last but not least, the mutual fund manager cannot rely on too much leverage — or owing too much money– as could be the case with investing in too many over-the-counter derivative contracts.
Not so with hedge funds, whose investment strategies and redemption gates are not regulated by the SEC. They are allowed to impose timetables in which shares must be held before they can be redeemed– anywhere from several months to several years. “Hedge fund managers wanting to enter the alternative liquid market will likely feel like a free bird now stuck in a cage, but stand to benefit from another source of management fees,” notes Baris.
Valuation Challenge
Because a mutual fund is required to strike a daily net asset value, it needs to price all the assets in its portfolio each day. For assets that are exchange-traded it’s a breeze. They just check out the last price listed on the exchange in which the equity is traded. However, they can’t do so when it comes to non-exchange traded assets — typically fixed-income securities and over-the-counter derivatives.
Hence, they will have to do a mark-to-market valuation to come up with a so-called fair value, according to Nicholas Tsafos, a partner at global accounting firm Eisner Amper in New York. That is the price at which the holding could be sold, and valution will rely on a combination of art and science–objective market data and other inputs and subjective pricing models and methodologies.
Although the legal liability for overseeing a mutual fund’s valuation rests with its manager’s board of directors, that board will designate the responsibility for actually conducting all the valuations on the mutual fund manager. The mutual fund manager might take on managing the new alternative alt on its own, but could decide to share the work with a subadvisor — aka a hedge fund manager — who may handle trading responsibilities which are beyond the mutual fund manager’s expertise. In doing so, the hedge fund manager may also need to value the non-exchange traded securities under its umbrella.
However, that doesn’t mean the mutual fund manager will have nothing to do. Quite the contrary. “It will have to verify that the valuation policies of the subadvisor meet the criteria of the fund’s board of directors before hiring the subadvisor. And once hired, will need to continually monitor its procedures,” says Tsafos. “The approach must be proactive, rather than reactive.”
That monitoring doesn’t necessarily mean talking on the phone or even reporting on the value of the non-exchange traded assets daily, he explains. However, it does mean establishing a means for the mutual fund manager to know when the price on the assets managed by the subadvisor must be changed; the reason for the change — most likely a change in market conditions — and how it will impact the net asset value of the overall alternative liquid fund.
“Managers of alternative mutual funds can’t afford to be surprised,” says Espen Robak, director of Pluris Valuation Advisors LLC, a New York-based valuation specialist. It’s important that they understand that market values can change quickly, even for illiquid securities. “If market movements are missed, because certain assets haven’t traded in a while, then that may necessitate a sudden mark-down later.”
Bottom line: fund managers need to be vigilant so their investors aren’t blindsided and start redeeming their shares en masse. When valuing illiquid assets, advises Robak, managers of hedge funds and alternative liquids should typically obtain valuations from three different external specialists and throw out the high and low valuations, instead relying on the mid-ranged one, with the presumption it will be the most objective. “Any outliers — or prices which deviate too far from the norm — should be eliminated and any discrepancies reconciled,” he says.
Although managers of alternative liquids face additional work pricing any non-exchange traded asset, some are more problematic than others. Case in point: a pre-IPO share. “Its value might not change that often before the IPO, but the difference between what the fund manager would price the shares before the initial public offering and the actual price when the company goes public could be dramatic and have a serious impact on the ultimate net asset value which must be struck daily,” says David Larsen, managing director at valuation service provider Duff and Phelps in San Francisco.
Two more examples, according to Amy Poster, director of risk and regulatory advisory services for C&A Consulting in New York: leveraged loans and long-dated options. “In the case of leveraged loans that trade by appointment, bond or loan credit default swap (CDS) prices can usually serve as a proxy. However, you have to account for basis risk because loans trade tighter than the CDS,” she explains. When it comes to long-dated options, volatility is a critical input in pricing and “vols” for maturities longer than two years are often unavailable. Therefore, a fund manager can either use implied or historical volatility. In either case, the figure may be just an estimate.
Other than making the best effort to value correctly and relying on third-party experts, documenting the methodology used and disclosing it to investors is advisable, says Larsen. Large mutual fund complexes can rely on their valuation committees, explains Poster, but smaller ones wanting to enter the liquid alt space would be well served to bring a risk manager working with controllers into the decision-making process.
Liquidity Risk
Valuations and liquidity are closely intertwined. Because mutual funds are required to redeem their shares within seven days of an investor’s request they cannot invest in too many assets which are illiquid — or would take a longer time to sell. They do have some breathing room in what they can buy, but must make a decision about whether or not an asset is liquid enough to purchase or whether it risks becoming more illiquid and must be sold. No more than 15 percent of the value of the fund can be invested in so-called illiquid assets.
“The investment management unit headed up by the portfolio manager will need to continually monitor liquidity of all the assets and incorporate the extent of liquidity into the price of the asset,” explains Robak. “The more liquid the asset on the scale of semi-liquidity, the higher the price. Less liquid assets should be priced lower, because of their lack of marketability.”
Not only does the SEC want to ensure the manager of the liquid alternative correctly monitors valuations and liquidity but also the amount of leverage. As a rule of thumb, the more over-the-counter derivatives in a portfolio, the higher the amount of leverage, because more payments will have to be made to counterparties. “Managers of alternative liquid funds will need to ensure they don’t breach the SEC’s limitations on leverage and ensure they set aside enough liquid assets to cover leverage obligations,” explains Baris. A fund manager can segregate assets by having a custodian mark liquid securities on the fund’s books to be used only to cover potential obligations resulting from leveraged investments.
Regardless of how diligently a liquid alt manager tries to adapt to SEC guidelines, human error and lapses in oversight can and will happen. The best safeguard to avoid costly mistakes is to have a robust governance and risk management framework to meet valuation and liquidity compliance controls, says Poster. It is also important to invest in IT infrastructure to manage leverage risk and enable accurate leverage reporting across investment strategies.
“Alt fund managers need to establish policies and procedures to address and immediately rectify compliance breaches,” says Poster. One way: rely on a combination of technology and solid oversight. Trading breaches, for example, are usually flagged by the compliance department. She recommends that, in addition, controllers and risk managers monitor daily concentration, position and trading limit reports.”These control points should not hesitate to provide constructive challenge to portfolio or trading desk managers when trading limits are violated,” says Poster.
Taking all the right steps will certainly help keep the SEC happy but there is one final validation which can be done before the SEC knocks on the door. “Check all the procedures in advance, test to make certain they work, and conduct a mock exam to make sure you can answer the SEC’s questions,” says Baris.