The SEC's Derivatives Proposal

First Impressions In December, the SEC released a document that addressed the derivatives usage of mutual funds (and exchange-traded funds). The commission has been busy over the past year, having submitted two proposals earlier in 2015, one on portfolio reporting and the other on investment liquidity. I thoroughly saluted the former and was of a mixed mind on the latter.

On the merits of this newest proposal, I will not yet write definitively. For one thing, Morningstar's Policy Committee has yet to issue its official response. By default, this article might appear to represent Morningstar’s views--and, per the disclaimer that follows this column--that is not necessarily so. For another, the proposal is long and its subject matter complex. Thus, I tread carefully.

But tentatively, I wonder if the SEC has devised a solution for a problem that does not exist.

To explain: The word "derivatives" has two meanings when used to describe financial instruments.

One meaning is to describe the situation when one security derives its price from one or more other securities. The value of a Treasury-bond futures contract is determined by the price of a Treasury bond; that of a stock market option from the behavior of the underlying stock; and that of a forward contract on the euro from how the euro trades relative to the dollar. The first variety of derivative takes its price from elsewhere.

The second meaning is of a security that was created from an older, parent security. One infamous example was the collateralized mortgage bonds of the 2007-08 housing crisis, which, like Frankenstein's monster, were created by combining body parts--in this case, the body parts coming from a pre-existing security of pooled mortgages. The second variety of derivative takes its behavior from elsewhere, but not its price.

One, But Not the Other The SEC's derivatives proposal addresses only the first flavor of derivatives. At first glance, such an approach would seem to make sense because that price-deriving breed of derivative carries leverage. Futures, options, forward contracts, swaps ... all require only certain minimum payments from the purchaser (or seller). Should the underlying asset that determines the derivative's price abruptly change in value, the derivative owner could conceivably be asked to put up more money, perhaps several times the derivative's current portfolio value.

The loss potential is therefore substantial. In contrast, the second form of derivative, the security that was spawned from another issue, is in theory no more dangerous than any other portfolio holding. As with a stock or bond, the second type of derivative can lose no more than its current value (that is, for a long position; the dicey math of shorting, wherein the shorted position can lead to unlimited losses, holds for all varieties of securities.) Thus, the SEC would seem justified in drafting rules that limit the leveraged type of derivatives but not the unleveraged variety.

Except that history suggests the opposite. In my memory, no fund has landed in trouble because of unanticipated behavior from futures, options, or forward contracts. It is true that some of the leveraged trading-equity ETFs--funds that use futures to become supercharged versions of stock markets (sometimes long, sometimes short)--have performed terribly. But those losses were by design; the futures performed as expected. They were not caught by surprise.

The only real problems with the first flavor of derivatives have come from customized bond swaps. In the middle of the last decade, some funds courted credit risk by trading the coupon payments of higher-credit bonds for those of lower quality. As the 2008 financial crisis loomed, those swaps performed badly, and the funds were forced to put up more cash as collateral. Such trades would indeed have benefited from oversight such as the SEC now proposes. However, even in those cases, the funds suffered more damage yet from their conventional positions. Entering 2008, it was bad to hold lower-quality credits, whether via swaps or by directly holding the bonds themselves.

In contrast, many funds have been clocked by owning the second form of derivatives. As known to readers or viewers of The Big Short, the collateralized mortgage obligations that were created from pools of housing mortgages found their way into many portfolios, among them mutual funds. In 2007-08, those securities caught their owners very much by surprise, and not in a good way. Similarly, in the '90s, derivative "interest only" and "principal only" bonds took down several funds, some of which subsequently faced SEC actions.

So, in the 30 years since the SEC last tackled the use of derivatives in mutual funds, standard derivatives contracts caused the fewest problems, customized contracts caused more, and derivative bonds (that is, the second type of derivatives) caused the most. Yet, the SEC’s missive appears to take the opposite priority.

Farewell, Managed Futures? Also, the derivatives proposal may have the result of eliminating certain liquid-alternative funds, in particular managed futures.

As the rules are currently written, funds may add 150% of leverage through derivatives if they move in a single direction--for example, by adding 150% exposure to the U.S. stock market via futures contracts on top of an existing 100% stock position (thereby leading to 250% effective exposure). That provision should preserve the existence of leveraged trading ETFs--a category that, unfortunately, does not much deserve preserving.

If funds do not use their derivatives to move in one direction but rather use them to cross-hedge, then they face a 300% gross limit with their derivatives positions. (Cross-hedging refers to taking a long position in one asset and a short position in a similar but not identical asset. Examples would be Treasury bonds of different maturity dates or large- and small-company U.S. stocks.) That would seem to eliminate managed-futures funds, as they are currently constructed.

I have not generally been a fan of managed-futures funds, which have tended to charge too much and return too little, but I would not wish to see them mandated to extinction.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.