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The Evolving Regulatory Landscape for Managed-Futures Mutual Funds

Managed-futures mutual funds face new regulations.

Terry Tian, 05/03/2012

With the rapid development of the derivatives markets and the proliferation of alternative mutual funds in recent years, regulators have struggled to keep up. On Feb. 9, after nearly two years of speculation, the U.S. Commodity Futures Trading Commission, or CFTC, announced a new set of rules. Futures-based mutual funds must now register as commodity pool operators, or CPOs, and they must disclose items such as underlying management and performance fees (in a break-even calculation) prominently in their SEC prospectuses.

Frustrated by the decision, the Investment Company Institute, or ICI, (a mutual fund industry association) and the U.S. Chamber of Commerce sued the CFTC on April 17, arguing the new rules were unnecessary because mutual funds are already overseen by the SEC. How the lawsuit will play out remains uncertain, but the conflict between the CFTC and the industry underscores the regulatory complexity of the managed-futures space.

The Current Regulation Regime and Its Problems
Although managed-futures strategies have been available in private fund format for decades, they only entered the mutual fund structure in 2007. Allured by the strategy's uncorrelated performance in 2008, investors have been pouring money into these newly launched funds since the financial crisis. The managed-futures category has received inflows of roughly $9 billion over the past four years, despite its recent lackluster performance. The number of funds available has exploded as well--there are now 31 distinct managed-futures mutual funds, 13 of which were just launched in 2011. The launches and inflows are somewhat surprising, considering the regulatory uncertainty that had been hanging over these futures-based products.

Unlike most mutual fund offerings, managed-futures strategies solely trade futures contracts and other derivatives (rather than stocks and bonds) to execute their investment strategies. As registered investment companies, they are subject to the oversight of the SEC. But theoretically, the CFTC has regulatory power over entities that trade futures and options. To further complicate the issue, U.S. tax laws haven't been written to accommodate futures held by mutual funds: The so-called "90% test" states that at least 90% of a regulated investment company's gross income each year must come from securities (commodity futures contracts, for example, do not count as securities). Otherwise, the investment company falls subject to corporate-level taxation.

Managed-futures mutual funds however, rely on an exemption rule from the CFTC and private letter rulings from the IRS to get around those regulatory obstacles. In 2003, the CFTC excluded registered investment companies, including mutual funds, from the definition of a CPO, citing they were "otherwise regulated." As a result, mutual funds did not need to register with the CFTC no matter what percentage of their portfolio was held in futures. The IRS has allowed futures trading through swaps or controlled foreign corporations, or CFCs, by private letter rulings, so that managed-futures mutual funds are able to establish the CFCs and trade futures through those offshore shell entities, thus avoiding the corporate tax.

The current arrangement creates two major problems, though. First, it encourages opaque disclosures on fees and subadvisor arrangements. Some managed-futures mutual funds hire commodity trading advisors, or CTAs, through the CFC structure. Because the SEC does not require the CFCs to report their underlying activities, these managed-futures funds are able to mask the identity of the underlying CTAs, as well as what the CTAs are trading, how much leverage they are taking on, and, most important, how much they are charging. These "fund-of-CTAs" structures are already pricey because they charge an additional layer of management fees plus hefty performance fees (charged by the underlying CTAs, typically ranging between 15% and 30%). Poor transparency acerbates the problem--it is very difficult to analyze these hidden costs if the fund does not voluntarily disclose them in obvious places.

Second, the special treatment granted to managed-futures mutual funds is unfair to other CPOs, which are not registered investment companies. Other publicly traded futures offerings, which do not hold status as registered investment companies, are regulated by the CFTC and are therefore subject to its stricter disclosure requirements. Managed-futures mutual funds have much lower minimum investment thresholds and presumably less sophisticated investors than other CPOs but carry out essentially the same strategies. It doesn't make sense for some players to be subject to a set of more rigorous regulations when all are competing in the same game.

Terry Tian is an alternative investments analyst at Morningstar.
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