Mutual fund directors grapple with risk, regulation

Complex risks connected to derivatives, liquidity, and trading mean that mutual fund boards must ensure they are equipped to address continuously evolving challenges, while not stepping over the line that divides oversight from day-to-day management

That was the key message from Securities and Exchange Commission Chair Mary Jo White this week when she delivered a keynote address at the Mutual Fund Directors Forum 2016 Policy Conference in Washington D.C. “From the perspective of the SEC’s mission to protect investors, there could hardly be anything more important than strong mutual fund boards when more than 53 million households—approximately 43 percent of all U.S. households—owned mutual funds in 2015,” she said. Fund assets have increased exponentially, from roughly $1 billion held by registered funds in 1940 to more than $18 trillion held by SEC registered investment companies in 2015.

Current offerings, like exchange traded funds, were not even contemplated in past decades and investment strategies have continually evolved, with some funds increasingly investing in less liquid securities and using more derivatives. “With these developments [are] new risks and challenges,” White said. Just as the SEC is taking steps to recalibrate its regulatory program for funds and advisers, independent fund directors “need to be vigilant in considering whether each fund is fully addressing current and potential future risks.”   

Two recent events serve as examples of operational and liquidity risks. In August 2015, a major service provider was unable to provide timely, system-generated net asset values for several fund families and alternative means of calculating NAVs had to be created. The second event, in December 2015, involved a mutual fund focused on investments in high yield and distressed debt that was forced to  suspend redemptions. 

White suggested questions mutual fund directors should ask management. How will the fund’s and its service providers’ compliance policies and procedures, business continuity plans, and back-up-systems address various situations? Are investments appropriately aligned with anticipated liquidity needs and redemption obligations? Is there an understanding of links that may exist between liquidity and valuation? Have fund management considered the back-up systems and redundancies of the critical service providers that value the fund, keep track of holdings and transactions, and strike net asset values?  Has fund management considered specific alternate systems or workarounds that may be necessary to continue operations and manage through potential business disruptions?

“Firms today rely on technology and third-party service providers for many key functions and a failure of just one can have potentially very serious consequences,” White said. “If your funds and their service providers do not have robust plans and procedures, you have some urgent business to attend to. But even funds that have such plans and procedures in place cannot just declare victory. No continuity planning or compliance policies and procedures, however thoughtful, comprehensive, and well-intentioned will address every issue and prevent all potential harm.”

Cyber-security is among the crucial considerations. In September, the SEC charged an adviser with violating Regulation S-P after a hacker stole sensitive information about more than 100,000 individuals from a web server. Recent staff guidance from the SEC encourages funds to assess their ability to prevent, detect and respond to cyber-attacks, and details measures funds may wish to consider.

Amid many operational and regulatory pressures, the line cannot become blurred between independent director oversight and day-to-day management. “It is incumbent on regulators to avoid completely overloading directors with additional responsibilities, or confusing strong oversight with the management of a fund,” White said. “It is obviously the fund’s adviser that is typically tasked with day-to-day management of a fund, and it is a fund’s chief compliance officer who is tasked with administering the fund’s compliance policies and procedures as approved by the board. The role of the board is to provide independent oversight of these and other critical functions, and to approve compliance policies and procedures, not to perform them.”

“Determining an appropriate dividing line is a challenge, White added, and “one that the SEC is grappling with as we consider proposed reforms designed to address the increasingly complex portfolios and operations of mutual funds and ETFs.”

Several of the Commission’s recent rule proposals for the asset management industry reflect the importance of determining an appropriate role for the board in addressing funds’ risks. Following a proposal last May on enhanced reporting for investment advisers and mutual funds, the Commission proposed liquidity risk management reforms in September. It would, for example, require a fund’s board, including a majority of independent directors, to approve a written liquidity risk management program, designate the fund’s adviser or officers responsible for administering the program, and review annual reports on its effectiveness. 

A December 2015 proposal regarding the use of derivatives by funds also addressed an oversight role for fund directors. It requires the board to approve one of two alternative portfolio limitations on the fund’s use of derivatives and to approve procedures for managing risks associated with derivatives transactions.