Donohue Expresses Concerns About Investment Companies' Use of Derivatives

Director of the Division of Investment Management Andrew Donohue is concerned that investment companies' disclosure regarding their use of derivatives, while technically compliant with the Investment Company Act, does not always help investors clearly understand the risks associated with derivatives. At the American Bar Association's spring meeting, he challenged industry participants to help develop solutions to the problems surrounding investment companies' use of derivatives. Donohue's remarks are posted on the SEC's Web site.

Mutual funds use derivatives for many purposes, including hedging interest rate, currency and other market risks, substituting for a direct investment in the underlying instrument, or increasing returns. The Investment Company Act limits the amount of leverage that investment funds may bear, and Donohue is concerned that the growing use of derivatives is quickly increasing leverage levels.

The last time the staff studied the issue was in 1994, at which time it concluded that fund use of derivatives was limited. The conclusion was drawn from staff inspections and from an Investment Company Institute survey on the issue. Although the staff found that fund use of derivatives was limited, Donohue said, several funds had recently experienced significant losses from investments in mortgage derivatives.

He noted that the 1994 study did not support a prohibition or restriction on the use of derivatives by mutual funds. The staff felt that restricting derivatives could chill the use of instruments in a manner that is beneficial for mutual funds, such as hedging. In addition, restrictions would be inconsistent with the general approach of the Investment Company Act, which imposes few substantive restrictions on mutual fund investments.

The staff also recognized that it would be difficult to craft appropriate restrictions on the use of derivatives by mutual funds because of the wide variety of instruments that may be considered derivatives. Instead, the study proposed dealing with the use of derivatives through improved risk disclosure.

As the use by investment companies of derivatives has increased and the variety of derivative instruments has grown since 1994, Donohue questioned whether fund disclosure has been adequate. He concluded that while disclosure has been compliant with Investment Company Act requirements, it has not always helped investors appreciate the risks associated with derivatives investments.

He cited the performance of fixed income funds in 2008 when a number of them suffered one-year losses in excess of 30%. Donohue said that some of the losses could be attributed to investment decisions concerning security selection, industry or sector concentration, or to the negative impact in a down market of bank borrowing-type leverage. However, the use of derivatives was also a factor, and he believes that investors did not appreciate the magnitude of the risk, and did not anticipate the large drop in value of the funds.

Donohue offered three specific concerns that he believes need to be addressed. First, he thinks funds should have a means to deal effectively with derivatives outside of disclosure. Second, a fund's approach to leverage should address both implicit and explicit leverage. Finally, he believes a fund should address diversification from investment exposures taken on versus the amount of money invested.

He acknowledged that there are many questions underlying these concerns, such as whether the application of Investment Company Act leverage restrictions to derivatives held by investment companies should be re-examined. He also asked whether the patchwork of stated Commission policy and staff positions regarding investment companies' use of derivatives is sufficient, or whether regulatory and legislative action is needed to address the leverage created by investment companies' use of derivatives.

Donohue also asked whether existing rules sufficiently address matters such as the proper procedure for investment company pricing and liquidity determinations of derivatives holdings, and whether investment company boards are exercising meaningful oversight of funds' use of derivatives, including risk management, proper accounting and internal controls.