Mutual Funds to SEC: Change Math on Swaps Exposure

Not all derivative contracts are created equal.

That is the message mutual fund managers are giving the US Securities and Exchange Commission about its proposal to limit their exposure to derivatives.

The SEC fears the growth in the use of derivatives by mutual funds and other registered investment fund advisers leading to greater financial losses. Its proposed rules, issued in December 2015, mark the first time the agency got specific on how mutual funds and other registered funds should curb their use of derivatives. Comments were due by March 28.

As drafted, the rules would curb the total exposure of mutual funds and exchange-traded funds to derivatives and other so called “financial commitments” to one of two thresholds: either an aggregate exposure of 150 percent of the fund’s net assets or 300 percent of the fund’s assets. The 300 percent figure would only be allowed if the fund satisfies a risk-based test based on value at risk (VAR). The fund must also show that using derivatives would subject investors to less market risk than if it didn’t. Registered investment fund advisers need to create a board-approved derivatives risk management program whenever their derivatives exposure exceeds the 50 percent threshold or consists of trades in “complex” derivatives.

At the core of the mutual fund industry’s opposition to the SEC’s proposal is its premise that exposure to any and all derivatives is harmful to investors. The SEC’s methodology for calculating risk exposure based on the gross notional value of the contracts is wrong, they say because it treats all derivatives has having an equal potential for investment loss. The SEC should consider alternative ways of calculating exposure to derivatives and other “financial commitments” based on the unique characteristics of each asset class and particular instrument.

“Fixed income funds that use interest rate swaps to mitigate duration risk, global equity funds that use foreign exchange forwards to mitigate currency risk and alternative strategy funds that invest synthetically to mitigate liquidity risk are all treated the same despite the relative risk presented in the specific derivative product type with a specific maturity and used for a specific purpose,” point out Mortimer Buckley, chief investment officer, and John Hollyer, head of risk management and strategy analysis at Vanguard in Valley Forge, Pennsylvania in a March 28 letter to the SEC.

Here is how they explain the potential differences in economic loss depending on the type of contract and its maturity: The seller of a credit default swap, say Buckley and Hollyer, may be obligated to pay an amount equal to or a smaller or larger portion of the derivative’s notional amount based on the value of the reference asset in a default compared to its par value. Derivatives involving more volatile underliers such as certain commodities present a greater likelihood of payment obligations approaching the trade’s notional amount. Likewise, a short-dated interest rate swap may present a more nominal level of risk than one with a longer maturity.

Alternative Calculations

So how should the SEC calculate exposure? How about applying standard risk conversion factors to the notional amounts, suggests Vanguard. Why? “Through the application of such factors, relative, objective risk assessments can be made based on product, underlier and residual maturity to establish more nuanced guard rails that will avoid some of the more harmful aspects of the proposed rule,” say Buckley and Hollyer. “Low risk products used to manage portfolio risk will not be subject to limits to the same degree as will higher risk products that may have more of a leveraging effect and therefore introduce a greater risk of loss to the regulated funds”

The risk conversion factors, say Buckley and Hollyer, should rely on those previously applied to determine whether derivative users meet the SEC’s definition of a major security-based swap participant (MSBSP). Those entities are required to be registered with the SEC and follow its rules on trading and processing of security-based swap transactions.

The Vanguard executives do recommend increases to the MSBSP conversion risk factors which, if applied, would give an interest rate swap of less than one year in duration a 0 percent notional amount conversion factor while one with a duration of more than five years a 10 percent conversion factor. Security-based swaps would have the highest conversion factors ranging from 40 percent to 66.7 percent.

Guggenheim Partners in New York suggested that the SEC rely on a margin-based approach in calculating exposure to derivatives. Such an approach, would put a limit on the percentage of a fund’s total assets that can be used as initial margin to 37.5 percent of total assets. That approach would be complemented by a heightened asset segregation requirement that a fund earmark on its books an additional amount of liquid assets equal to the total initial margin requirements for all of its derivatives. A fund with a 37.5 percent initial margin would be required to segregate an additional 37.5 percent in liquid amounts while fund with 5 percent initial margin would be required to segregate and additional 5 percent in liquid assets.

Here is how the 37.5 percent initial margin cap would work, according to Guggenheim Partners: for a fund that uses equity swaps that require 15 percent initial margin, the initial margin calculation would limit the equity fund’s swap exposure to 250 percent of the fund’s assets. The 250 percent is obtained by dividing 37.5 percent by 15 percent.

Why is the margin based-methodology the best approach? “A margin-based approach would be more responsive to evolving market conditions than a fixed portfolio limitation or a VAR approach (which is based on a look-back period and may not capture spikes in volatility),” argues Donald Cacciapaglia, vice chairman of Guggenheim Partners. “Additionally, a margin based approach would be objective and relatively simple to implement and funds already have most of the necessary infrastructure to comply with the requirements.” The heightened asset segregation would also limit the fund’s ability to obtained leveraged investment exposure. If the fund faced significant margin calls requiring it to exceed its initial margin cap, the fund would have sufficient assets to cover the insufficiency and reduce its positions to comply with the initial margin cap, says Cacciapaglia.

The Pacific Investment Management Company (Pimco) offered a less radical approach to how the SEC should amend its risk metric. It argues that the most precise way in which a risk adjustment can be made based on the relative risk of the underlying asset would be a “duration-weighted adjustment” based on a reference security. However, such a methodology would be used primarily for interest-rate sensitive securities. Asset classes that are not risk-sensitive would be counted at their full notional amount.

“Using the [duration-weighted adjustment] the notional amount of a particular derivative would be multiplied by the ratio of the derivative’s duration and the duration of the reference security,” explains Douglas Hodge, chief executive of Pimco, based in Newport Beach, CA. Such a methodology, he says, would reflect the reduced volatility of shorter duration securities to longer duration securities. Hodge recommends that the SEC rely on a thirty-year bond as the reference security because it has volatility approximating the S&P 500 index.

In addition to lobbying against limits to exposure based on the notional gross value of derivative contracts, mutual funds disputed the SEC’s requirement that a narrowly constructed value-at-risk test be the cornerstone for raising the threshold of exposure for hedging transactions to 300 percent. BlackRock, for one, suggested that instead of using only one VAR approach which strictly depends on whether derivatives are used to hedge overall portfolio risk, the SEC consider two additional approaches which take into account alternative investment strategies. Those are the “active” VAR test for funds that use derivatives to align portfolio risk to benchmark risk and the “absolute” VAR test for funds that use derivatives for economic exposures. Under the absolute VAR methodology funds could rely on the higher 300 percent threshold if their one month 99 percent VAR was limited to 15 percent.

“Permitting three VAR tests will avoid precluding certain types of derivatives that we believe are consistent with the Commission’s intentions in proposing the VAR test while continuing to ensure that all funds are limited to obtain leverage through the 300 percent limit,” say Barbara Novick, vice chairman and Benjamin Archibald, managing director of BlackRock in New York. If the SEC insists on the one-size-fits-all VAR approach, it should rely only the absolute VAR methodology. Funds would still be required to abide by the 300 percent limit which will significantly limit their ability to use substantial amounts of derivatives.

In addition to changing the math the SEC uses to measure risk exposure to derivatives, say mutual fund executives, the SEC should also exempt some types of transactions, asset classes and types of funds from the calculations. Securities lending deals were the most often cited for exclusion as were exchange-traded funds. Currency-forward contracts used to hedge non-dollar denominated currency fluctuations were also favored to be exempt. “One-to-one hedging for non-US dollar assets of the fund with foreign currency forward contracts can be identified easily within the fund and it also ensures that the fund has the assets necessary to cover the derivatives position,” says Marc Bryant, chief legal officer for Fidelity Management & Research Company in Boston.

Ease Up on Program

Mutual fund managers also took some time to poke holes in the agency’s guidelines for a derivatives risk management program. That program would include the appointment of a dedicated derivatives risk manager, approved by a fund’s board. The board would also be responsible for approving the program and changes implemented by the specialist risk manager on a quarterly basis.

Mutual fund managers caution that while fund boards should have some oversight, they should not be involved with approving specific limits on derivative transactions, models for assessing risk and other management tools. That should be the job of the investment adviser. The reason is two-fold: “First, the typical fund director may not have the technical expertise to apply VAR, leverage factors and other risk-based methodologies to assess the reasonableness of the limit with respect to the fund’s investment program,” says David Oestreicher, chief legal counsel for T.Rowe Price in Baltimore. “Second, we fail to see conflicts of interest if the fund manager were to make this determination — which generally should be an important factor for requiring board approval for any action determined by the manager.”

Mutual fund managers also urged the SEC to ensure that derivatives risk managers have no personal liability for decisions which harm the performance of a derivatives transaction or ita effects on a fund’s portfolio. The rationale: they can’t predict the future with any certainty. “As with any risk management relating to investments generally, decisions regarding derivatives risk management are fundamentally forward-looking in nature,” say Paul Roye, senior vice president, and Erik Vayntrub, counsel for Capital Research and Management Company in Los Angeles. The only criteria the SEC should use is whether the decisions were made with a “reasonable degree of care” by a qualified risk manager.

Fidelity called on the SEC to ease up on its rules for when the derivatives risk management program must be implemented. Mutual funds shouldn’t have to do so immediately after they reach the 50 percent threshold. They should be allowed to extend the threshold to 70 percent for one fiscal quarter as long as they return to the lower threshold in the next fiscal quarter. “We expect that significant time and resources will be necessary to develop and implement a formal derivative risk management program,” says Fidelity’s Bryant. “We believe it would be impractical to require a fund that temporarily exceeds the 50 percent threshold to adopt a permanent program if the fund intends to fall below the threshold within a reasonable time period.”

Likewise, fund managers should’t have to adopt a derivatives risk management program for executing even one complex derivative trade, says Bryant. It should be a “de minimis amount” — such as one percent of a fund’s net assets based on the complex derivative transaction’s risk adjusted notional value.