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Wednesday, August 26, 2009

Style Purity and Actively Managed Mutual Funds....There May be Exploding Derivatives in That Portfolio...And You Likely Won't Know About It

I wrote earlier about the importance of style purity of one's holdings and that active funds often don't have that purity. I also noted that it is impossible to know the current holdings of a fund since the data is published in arrears.

The problem is even worse. As Investment News reports investors seldom know if the mutual fund they hold makes use of leverage:(my bolds, my comments in bold italics)

An American Bar Association task force studying mutual funds' use of derivatives will likely recommend measures to ensure that investors and fund directors are better-informed about the risks associated with the use of the complex financial instruments. ...

Although the Investment Company Act of 1940 limits the amount of leverage a fund may carry, the SEC hasn't imposed specific limits on a fund's use of derivatives, in part because derivatives are often used by funds to hedge against risk.

“These limits were structured when derivatives didn't exist,” said Jay Baris, chairman of the task force and a partner in Kramer Levin Naftalis & Frankel LLP of New York.

“A whole world of derivatives has evolved,” he said. “The SEC is struggling to keep laws and regulations in sync with these developments.”

The task force expects to release its preliminary findings in November.

Simpler disclosures aimed at retail investors could be in-cluded in fund prospectuses, while more detailed, technical disclosures could go into the statement of additional information, he said.

“Disclosure is critical,” said Eric Jacobson, a mutual fund analyst at fund research firm Morningstar Inc. in Chicago. “Even though there's always been skeletal data in the reports that the fund companies make to the SEC, there hasn't been enough detail for the average investor or even the average intermediary like a financial planner or broker. [Regulators] need to come up with standards for what information has to be disclosed.”

The use of derivatives by mutual funds caught the eye of regulators last year after some fixed-income funds posted steep declines as a result of investments in derivatives. Such investments, for ex-ample, caused the Oppenheimer Core Bond A Fund (OPIGX) to lose 35.83% in 2008, compared with a 5.3% gain for its benchmark, the Barclays U.S. Aggregate Bond Total Return Index, according to Morningstar.

Oppenheimer is the cautionary example of what can go wrong,” Mr. Jacobson said.

Here is an extreme example of you don't know what you own when you invest in an actively managed mutual fund. Imagine the impact on a portfolio for the investor that chose the Oppenheimer for his bond allocation. And the bond allocation is usually intended as the most conservative part of a portfolio.

No one at OppenheimerFunds Inc. of New York would be made available to comment last week, Katherine Herring, a spokeswoman for the firm, wrote in an e-mail.

In addition to improved disclosure of funds' use of derivatives, fund board oversight is an issue on which the task force is focusing, Mr. Hirsch said.

“It's a very important control,” he said. “The people overseeing the fund adviser must understand the trading technique.”

Mutual fund consultant Burton Greenwald agrees.

“There has to be some oversight in respect to consistency with the funds' investment charter and disclosure,” said Mr. Greenwald, the managing director of B.J. Greenwald Associates, a Philadelphia-based fund consulting firm.

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