The Division of Investment Management again has turned its attention to alternative mutual funds, this time ensuring that they adequately disclose risks to retail investors. 

In a speech to the SIFMA Complex Products Forum on October 29, 2014, Norm Champ, the Director of the SEC’s Division of Investment Management, called for alt funds (and all funds that use alternative strategies) to assess the accuracy and completeness of their disclosures, including whether the disclosure is presented in an understandable manner using plain English.[1]

Although alt funds accounted for only 2.3 percent of total mutual fund assets as of the end of 2013, they represented 32.4 percent of the inflows of the entire mutual fund industry. As of the end of September 2014, alt funds account for $242 billion of industry AUM. This growth has attracted the SEC’s attention.

Champ’s comments may be a harbinger of enforcement investigations and proceedings to come, as the Office of Compliance Inspections and Examinations (OCIE) drills down on valuation, liquidity, and leverage – areas that present heightened risks for alt fund investors.

In his October 29 speech, rather than addressing potential substantive regulation of these areas, Champ focused on risk disclosure. Acknowledging that concise risk disclosures are more difficult to draft when funds use complex investment strategies, he nonetheless emphasized the importance of ensuring that disclosure gives the “average investor” information needed to make informed investment decisions. This push for concise disclosure arises in the context of concerns that “there could be a disconnect” between the strategies and risks that alt funds disclose versus the strategies that these funds actually employ.

To be sure, we can expect that OCIE will zero in on how alt funds disclose their strategies and inherent risks, and compare the disclosures to what it finds when it looks under the hood, especially when funds employ derivatives, including futures. What kinds of disclosures will OCIE look for? According to Champ:

An alternative mutual fund should, for example, disclose material risks relating to volatility, leverage, liquidity and counterparty creditworthiness that are associated with trading and investments in alternative investment strategies, such as derivatives, that are engaged in, or expected to be engaged in, by the fund.

This means that funds should not simply list investment strategies and risks. Rather, funds must disclose “a complete risk profile of the fund’s investments taken as a whole” and reflect “anticipated alternative investment or asset usage.”

Moreover, a fund should “assess on an ongoing basis the completeness and accuracy of alternative investments-related disclosures in its registration statement in light of its actual operations.” The goal is to ensure that risk disclosure in fund prospectuses and marketing materials are in synch with a fund’s actual current strategies.

Our take: Champ’s speech could indicate the direction of OCIE examinations and enforcement referrals in the coming months. It seems likely that the staff will compare how funds disclose risks to how those funds actually manage their portfolios, and try to identify anomalies. This approach, in turn, will increase pressure on fund directors, who must “assess on an ongoing basis” whether (i) fund disclosures are consistent with what funds are actually doing, (ii) the disclosures reflect the fund’s overall risks, and (iii) the average investor can understand those disclosures.

That said, the speech, by itself, does not indicate whether we can expect the staff or the SEC to issue or propose any additional substantive guidance on the regulation of derivatives and leverage.


[1] Morrison & Foerster LLP was one of the sponsors of the SIFMA Complex Products Forum.