Wednesday, January 6, 2016
Author: David Schwartz J.D. CPA
As a companion to the SEC’s recent proposed rules on the use of derivatives by registered investment companies, the SEC’s Office of Risk Analysis has published a white paper studying just how funds use derivatives. Based on data from Forms N-CSR and N-SAR supplemented with information from Morningstar, the study’s authors assembled data on derivatives positions held by 10 percent of funds registered in 2014. Because section 18 of the Investment Company Act restricts the ability of a fund to issue “senior securities,” the study focuses on those derivatives (and certain financial commitment transactions) that implicate section 18. These kinds of derivative positions can potentially present “senior security” issues because a fund that enters into these transactions is or may be required to make a payment or deliver cash or other assets during the life of the instrument or at maturity or early termination.
Despite the perceived increase in the use of derivatives, there is currently little systematic evidence on their use by funds. Using the sample selected, the white paper investigates the extent to which funds use derivatives, including the types of derivatives and types of risk exposures, as well as the aggregate exposure. In addition, the authors examined (1) the regulatory background, (2) recent trends in fund’s use of derivatives, and (3) fund policies regarding derivatives and a high-level analysis of their use.
Though not a comprehensive study of how funds use derivatives, this whitepaper provides some valuable insights into the kinds of derivatives transactions the SEC seems to be most concerned with when it comes to mutual funds and BDCs, those that have leverage and senior security implications.
 Because the term, “derivatives,” is somewhat expansive, for the purposes of the study, the authors limited their sampling to include the use of futures, swaps, currency forwards and written options. They excluded other types of derivatives, like purchased options and purchased swaptions because, though sometimes employed by funds, these types of derivatives do not create Section 18 senior security issues because they to not impose a payment obligation not he fund beyond its investment.