The Friday List: 5 Things You Should Know About the Fund-of-Funds Rule and the Derivatives Rule
Today, we offer our “Friday List,” an occasional feature summarizing a topic significant to investment management professionals interested in regulatory issues. Our Friday Lists are an expanded “Our Take” on a particular subject, offering our unique (and sometimes controversial) perspective on an industry topic.
Lost in all the tumult over the presidential election and the pandemic, the SEC recently adopted a new fund-of-funds rule (12d1-4) and a derivatives rule (18f-4) for registered funds. The industry has lobbied for both of these initiatives for several years, and their impact will have far-reaching effects on the fund industry. The fund-of-funds rule allows the acquisition of underlying funds in excess of statutory limits without obtaining an exemptive order. We believe that the rule will facilitate product development and allow smaller fund companies to compete more effectively. The derivatives rule adds several compliance and reporting requirements but offers more certainty for funds and boards to utilize derivatives both for performance and for hedging. The rules are complex and the proposing releases (Release No. IC-34045 and Release No. IC-34084) are long and detailed, so we recommend that you review the memos that our own Daniel Holtzer prepared on each of the fund-of funds rule and the derivatives rule and consult your favorite fund lawyer before going forward. To get you up to speed, we offer five things you should know about each rule.
5 Things You Should Know About the Fund-of-Funds Rule and the Derivatives Rule
Fund-of Funds Rule (12d1-4)
- Allows registered mutual funds, ETFs, UITs, closed-end funds and BDCs to purchase underlying funds in excess of the statutory limits imposed by Section 12 of the Investment Company Act
- Rescinds all prior exemptive orders for transactions within the scope of the rule as well as Rule 12d1-2 (investments within affiliated group of funds)
- An acquired fund must negotiate an agreement with the acquiring fund to ensure no undue influence
- There can be no duplication of fees
- Mirror proxy voting is required if certain ownership limits are crossed
Derivatives Rule (18f-4)
- Applies to mutual funds (other than money market funds), ETFs, closed-end funds, and business development companies that have more than 10% exposure to derivatives
- Fund advisers must adopt a Derivatives Risk Management Program that includes stress testing, backtesting, internal reporting and escalation procedures
- The Board must approve an experienced Derivatives Risk Manager (other than the fund’s portfolio manager), who must implement policies and procedures designed to facilitate derivatives risk management and report to the board regarding their implementation and effectiveness.
- The fund must observe risk limits based on value-at-risk, which cannot exceed 200% of the VaR of the fund’s designated reference portfolio
- Funds must report derivatives program information on Form N-PORT and N-CEN