I was lucky enough to attend a mini-seminar on setting up managed futures based mutual funds last week, and was shocked by most of what was being said. Looking around the room, most people were drooling over the possibilities present for raising assets, but a select few (myself included) seemed to be thinking-
Is this what the seminar on the financial innovation called mortgage backed securities was like 15 years ago?
While the term “innovation” may bring to mind thoughts of progress, growth and success- especially in a business sense- the phrase “financial product innovation” riddles the pages of analysis on the 2008 Credit Crisis. Here, creative structuring of investment vehicles and instruments such as mortgage backed securities, interest only loans, credit default swaps and more – spun at the time as “financial product innovation”- wound up center stage in the midst of the scandals that followed. Some speculated that the blow-up would be the end of financial product innovation, but as this seminar revealed, that couldn’t be further from the truth.
At the heart of the matter – the SEC’s rules that futures trading can not be more than a certain percentage of the investments of the mutual fund (some of the panelists were actually referring to the futures part as the ‘bad’ money). Now, this would seem to be a death knoll for those looking to launch a ‘managed futures’ mutual fund which invests in managers (or a single strategy) which utilize futures markets exclusively. The assumption with such a fund would be that the fund invests 100% of the investor’s money into managed futures.
But the financial innovators quickly found out that managed futures usually only use about 10-15% of the total equity in the portfolio for margin, meaning they could put 75% or so of the mutual fund’s assets in treasury bills or the like to meet the requirements that a certain percentage be trading securities, and the 25% is left over to margin the futures trading.
While this meets the letter of the law, I suppose, I’m not sure that is what the SEC intended when setting up the percentage differential. Let’s take a hypothetical $100 million managed futures mutual fund. Out of that $100mm, $75mm would be invested in ‘good’ money, the allowed securities for a mutual fund, and $25mm would be invested in the ‘bad’ money (futures based stuff). Now, the managed futures positions are not being sized on the $25mm on that side of the equation, however – they are being sized on the full $100mm (to give investors full exposure). So, assuming an average margin to equity ratio of about 12.5%, we can know that there is about $12.5 million worth of positions on the ‘bad’ money side, versus $75 million on the ‘good’ money side. This is what the innovator’s point to as saying they have met the letter of the law.
But not so fast- If we assume a normal built in futures leverage of around 8 to 1, that $12.5 million on the ‘bad’ side is actually representing a nominal investment level of $100 million, which is obviously more than the $75 million on the ‘good’ money side.
And if you look at any other measure of how the assets are split up, the ‘bad’ money side dwarfs the ‘good’ money side. The bad money side would be over 90% of the portfolio’s return, volatility, drawdown, other expenses (i.e. mgmt. and incentive fees).
It’s like a parent telling you that you can only spend 25% of your money in the candy store – so you split up your 10 pieces of money into two piles, one pile having 8 one dollar bills (80% of your money), and the other pile having 2 twenty dollar bills (20% of your money). You then go spend $40 in the candy store, meeting the letter of the law, but ignoring the intent.
Other noteworthy lessons learned included:
- How to get around the rule where a sub advisor to a mutual fund can’t get paid an incentive fee: Just don’t list yourself as the sub-advisor. Instead, manage the money of a sub corp., and have the mutual fund invest in the securities of that sub-corp. The sub. corp. pays your incentive fee, not the mutual fund.
- How to get around listing all of the fees: Just bury them in the notes or ‘other fees’ section of the semi-annual report, leaving your expense ratio at a small 1-2%.
- What the result of the NFA’s letter to the SEC saying these mutual funds are commodity pools and shouldn’t be exempt from the regulations of such was: The decision is in limbo (nothing has been decided since the 2006 letter), but the market has exploded for these products and it’s too late to shut it down now.
These products definitely serve a purpose, giving those that don’t have $100,000 or more to invest in an individually managed ‘managed futures’ account access to the space. And many of the people in the room were good people, with the investor’s best interest in mind. Their general comment would be something along the lines of – we’re all for being compliant, just tell us what the rules are.
But the lesson learned for me was that financial product innovation is alive and well, and WAY ahead of the regulators on both sides of the fence. Here is a prime example where the products are being launched before the regulators have had a chance to establish the proper regulatory infrastructure to handle them. Whatever rules they come up with, there are armies of lawyers and market players ready, willing, and (most importantly) able to figure out how to still get done what they want to get done within the letter of the law, if not the intent.