SEC Commissioner Kara Stein is worried that mutual fund sector is moving beyond the reach of the regulators.

Stein addressed the issue this week in a speech this week at the Brookings Institution, a Washington think tank, where she encouraged the SEC to revisit the investor protections laid out in the 1940 Investment Company Act, the foundational statute governing the fund industry.

Stein praises that law, which along with the Investment Advisers Act turns 75 this year, for implementing much-needed safeguards such as liquidity and redemption requirements. Though she credits the fund industry as a great success, one that plays a "vital role" in the investment landscape, Stein says she worries that some complex and exotic products are moving away from some of those rules.

"I'm concerned that we're starting to see some cracks in the foundation of this framework that we should all be thinking about. In some ways, it appears that registered funds have slowly drifted toward a more flexible and permissive disclosure regime," she says.

"This drift increasingly places the onus on the retail investor to figure out whether a fund is right for him or her," Stein adds. "And the retail investor, who generally tends to be less sophisticated in financial matters, might not even understand what he or she needs to know to make that decision."

Stein's comments come amid an ongoing review of the asset management industry and the applicable regulations at the SEC, an initiative commission Chair Mary Jo White detailed last December. Through that review, the SEC is considering an expansion of the data that registered funds must report to the commission and make public. Staffers are also evaluating whether to impose new liquidity requirements and restrictions on the use of derivatives within the fund industry.

TRANSPARENT INVESTMENT

Stein did not endorse any specific policy proposal in her remarks, though she seemed to argue forcefully that changes are in order to ensure that funds remain a viable and reasonably transparent investment avenue for the retail community.

She frames her concerns in the context of the continued growth of the U.S. fund industry, noting that investors are increasingly relying on mutuals and exchange-traded funds to finance their retirement or college tuition for children or grandchildren.

According to the Investment Company Institute, U.S. mutual funds and ETFs counted some $18 trillion in assets at the end of 2014, accounting for more than half the global market. That translates into more than 90 million Americans -- almost a third of the U.S. population -- holding some investments in registered funds. And 89% of the fund assets are held by retail investors, the ICI reports.

"So, as we note the 75th anniversary of the Investment Company Act, we also should acknowledge that the funds that are organized under the act have never played a more important role in our country or our economy," Stein says.

However, Stein argues that some funds are moving away from the "bright-line protections" that investors have come to expect from the industry, particularly in the area of liquidity.

She notes the increasing popularity of funds that invest in bank loans, a segment that has soared nearly 400% since 2009, but that seems to stray from the liquidity requirements prescribed in the 1940 Act. Stein argues that since many of the bank loans underpinning those funds can take longer than a month to settle, "it is reasonable to wonder how the fund could possibly meet the seven-day redemption requirement in the Investment Company Act in times of market stress."

'CLEVER BOOKKEEPING'

Likewise, the SEC has issued guidance capping the portion of a registered fund's assets that can be invested in illiquid securities at 15%, though Stein observes that some funds "may be comprised almost entirely of illiquid bank loans, which would seemingly violate the [liquidity] threshold."

But through a bit of clever bookkeeping, some funds have been moving away from the spirit of that requirement, while still adhering to the letter of the rule. As a result, the "liquidity standard has arguably become more of a compliance exercise than a true restriction," she says, in the process stripping away an important protection for retail investors

"[T]he liquidity of registered funds is one area where it seems that regulation has drifted into 'buyer beware,'" Stein says. "A retail investor looks at a mutual fund, expects that he or she will be able to get money out of a fund very quickly as needed. A retail investor is generally not performing cash-flow analyses on mutual funds to test their true liquidity."

Likewise, Stein warns about the increasing use of derivatives that has seen some funds take on more leverage than was intended by the 1940 Act.

"Unfortunately, this cornerstone principle appears to have gradually eroded as well. Derivatives usage by registered funds has skyrocketed in the past couple of decades," Stein says.

She points out that in the run-up to the Great Depression in the 1920s, many of the investment companies and trusts that collapsed were heavily leveraged, "rife with abuse," and "were often receptacles for the unloading of worthless securities." She cautions regulators to recall that lesson and ensure that leverage within the fund industry is kept in check.

"This might sound eerily familiar to those of us who recently went through the recent financial crisis," Stein says. "Going forward, the commission's approach must reflect the Investment Company Act's foundational principle that leverage be limited in registered funds."

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