Two Key Issues For The Fund Industry
In a recent address, the Director of the SEC’s Division of Investment Management, Andrew J. Donohue, made two key points regarding future regulation. Keynote Address at the Practising Law Institute’s Investment Management Institute 2009, April 2, 2009. In discussing one trend of concern, the director called for the industry to review the use of leverage by some funds. In the second, Mr. Donohue noted that the Commission is undertaking a top to bottom review of regulations regarding money market funds. His remarks came just days after Treasury Secretary Tim Geithner outlined a blueprint for addressing systemic risk in the financial sector. Testimony of Treasury Secretary Tim Geithner, House Financial Services Committee.
Director Donohue made two significant points regarding the future of regulation and the industry. First, he identified as “worrisome” the increasing use of leverage by funds. While he noted that this factor is being properly disclosed Mr. Donohue expressed concern as to whether many retail investors would fully appreciate the impact of this trend: “While sophisticated investors might have the ability to properly evaluate the impact of employing leverage in funds, I question whether many retail investors can.”
The director went on to give an example of this trend, noting that a fund “that sought to provide a return of 200% of an index on a daily basis, apparently do so but the result in the long term was, I believe, quite disappointing. The Index was down about 5 percent, and the fund, seeking 200% of that return daily, was down over 21 percent. For a longer period that index was up 50 percent yet the leveraged fund was actually down over 20 percent. That is correct, the index was up 50 percent and the leveraged fund was down 20 percent. Now, I suspect all the disclosures were there and the find did what it said it would, but who would expect that result.” He went on to note that there are many other extreme examples.
In view of these prospects, Mr. Donohue called for the industry to take a serious look at this issue. While the Commission is not what he called a “merit regulator,” and Funds which properly make all the necessary disclosures will not be held up by the Division of Investment Management, this trend should be examined by the industry.
Second, Mr. Donohue addressed money market funds. As the current credit crisis unfolded, money market funds began experiencing difficulties in the fall of 2007. At that time the residential home mortgage market first impacted money market funds’ holdings of commercial paper issued by structured investment vehicles. Investors began avoiding asset-backed commercial paper. By September 2008, as credit tightened there was the first ever “breaking of the buck” by a widely held money market fund. Fortunately many money market fund sponsors or their parent firms voluntarily stepped in to assist funds facing credit or liquidity challenges.
The director went on to note that the choice of the $1.00 instead of $10.00 per share NAV has made the NAV insensitive to losses and gains in the funds’ portfolios. This lack of sensitivity gives large investors the opportunity to take advantage of a fund and its other shareholders. “An example … Assume a money market fund has a loss on investments of 0.04% so that its NAV is now $0.9960, which is $1.00 and within the one-half percent deviation permitted under current rules. If the investors who own 25% of the fund redeem at $1.00, the NAV is now $0.9947 or $0.99 per share. Sophisticated investors know this dynamic and will redeem their shares in the fund quickly, leaving the loss for the remaining shareholders. What had been a loss of 40 cents on $100.00 for remaining shareholders is now $1.00 on $100.00 because they did not abandon the fund quickly enough. I question whether this is appropriate and whether it increases the possibility and probability of a run on a money fund.”
In view of these prospects, the Division of Investment Management has as one of its top priorities for the year a review of the money market fund model and the related issues. The division intends to conduct this review in cooperation with the fund industry and fund investors with a view toward updating the regulations. This review is consistent with Mr. Geithner’s congressional testimony in which he called for the SEC to develop strong requirements for money market funds to reduce the risk of rapid withdrawals. This is part of the Administration’s plan for overhauling financial regulation.