SEC Study Ordered on Mutual Funds' Use of Derivatives

Strategic Insights -

Representative Edward J. Markey, chairman of the House subcommittee on telecommunications and finance, has asked the Securities and Exchange Commission to conduct a comprehensive study on the use of derivatives by mutual funds. The request comes after sharp price drops for several low-risk mutual funds, which have been found to have invested heavily in complex financial instruments known as derivatives. Derivatives are financial products whose value is based on the movement of a financial market, such as stocks, bonds, or commodities. Many mutual funds have substituted derivatives for other investments, often in the form of structured notes, which are bonds linked to an index of the stock market or another asset.

Key Takeaways:

  • The Securities and Exchange Commission has been asked to study the use of derivatives by mutual funds, following recent sharp price drops for several supposedly low-risk funds.
  • Most mutual funds that have gotten into trouble have held mortgage derivatives, complex bonds backed by pools of home mortgages.
  • The chairman of the House subcommittee on telecommunications and finance, Representative Edward J. Markey, has asked the SEC to review several issues posed by derivatives, including whether fund practices are disclosed clearly to average investors.
  • Mutual funds have been accused of taking too much risk to raise their yield, and derivatives have been criticized for being hard to value, sell, and sell for more than is generally permitted for mutual funds.
  • The SEC has already begun several initiatives in response to mutual funds' growing use of derivatives, including a letter to fund managers asking for increased disclosure of derivative activities.
  • The agency is also planning to send a second letter asking fund managers to review their risk management controls that track derivatives positions.

Statistics:

  • The Paine Webber short-term government bond fund fell 4 percent in one day due to illiquid mortgage derivatives.
  • The request for the SEC study is to be completed within 30 days.