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Mutual funds breaking the law?

By Sheyna Steiner · Bankrate.com
Friday, September 2, 2011
Posted: 9 am ET

Regulators have been examining the issue of derivatives in mutual funds since March 2010 but on Wednesday of this week the SEC requested comments from the public.

Derivatives are investments that are based on the value of something else. For instance, futures contracts are derivatives, the contract is worth a certain amount based on the underlying assets. But derivatives can be based on a number of different things such as stocks, bonds, commodities, indices and options.

One problem regulators have today is that the landscape of the investment industry has vastly changed since laws governing mutual funds were put into effect.

According to the Bloomberg.com story, "Mutual funds face curbs on using derivatives," the use of leverage in mutual funds is restricted by the 1940 Investment Company Act. As well, the SEC's "regulation of mutual funds' use of derivative is based on a 1970 agency release, known by the number '10666,' which didn't specifically mention derivatives," the story reports.

While mutual funds are limited in the amount of leverage they can use, the use of derivatives is only vaguely regulated.

That's a problem because using derivatives involves leverage, or borrowing, according to the SEC press release soliciting comments.

Among the issues of regulating derivatives is measuring the amount of leverage that a fund takes on when investing in a derivative.

The SEC also asks:

"How should a fund value a derivative to determine the percentage of the fund's assets that is invested in a particular company for diversification purposes?"

"How is investing in a derivative issued by a broker-dealer different, or similar to, investing in the broker-dealer's stock or bond?"

"How do funds determine the industry or industries to which they may be exposed through a derivative instrument?"

"Should the Commission issue guidance on how funds value derivatives in their portfolios?"

Though there are many reasons mutual funds might use derivatives, one regulatory hurdle for mutual funds is coming up with a daily valuation for some derivative products. Mutual funds must ascertain their share price every day and in some cases, pricing derivatives can be tricky. It is not always a transparent process.

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