Hungry for healthier returns, more mutual funds are investing in commodities, commodity futures, swaps and options.

In turn, regulators-particularly the Commodity Futures Trading Commission (CFTC)-are tightening oversight to try and make sure none play fast and loose with either the law or good marketing practices.

The core concern: A growing number of funds can skirt laws designed to cap their exposure to commodities.

"The mutual fund industry's $50 billion investment in commodity markets is continuing to grow and merits a cop on the beat with a focused interest in protecting commodity markets from wrongdoing," wrote Senator Dianne Feinstein, chair of the subcommittee on Energy and Water Development Appropriations and Senator Carl Levin, chair of the Senate Permanent Subcommittee on Investigations, in a November letter to the CFTC.

Besides over-exposure to commodities, regulators also fear inadequate disclosure of information about the brokers involved, known as futures commission merchants, or the performance of the funds that make the investments in commodities. Also unclear can be who is actually managing a fund, the fees being paid and the risks involved.

In some cases, according to the National Futures Association, funds market themselves to unsophisticated retail investors as commodity pools, when they are not registered as such. Others are, in the words of Levin, creating "offshore shams" to get around rules governing investments in commodities.

Partly as a result, the CFTC voted earlier this month to amend Rules 4.13 and 4.5 of Title 17 of the Code of Federal Regulations to make it significantly harder for mutual funds to avoid its purview. For instance, mutual funds now must register as commodity pool operators if they trade more than 5% of their liquidated asset value in speculative commodities trading.

Likewise, the Internal Revenue Service suspended in June its practice of writing ruling letters that allow these funds to set up offshore corporations and engage in a level of investing in commodities that, if they were operating back in the States, would violate Internal Revenue Code Section 851(b)(2), which prohibits an investment fund such as a mutual fund from putting more than 10% of its assets in alternative investments, including commodities.

Moreover, the Securities and Exchange Commission is expected to work more closely with the CFTC to search for fraudulent disclosure and marketing.

The commodities sector has seen an explosion in mutual fund activity, according to statistics prepared for a Jan. 26 hearing held by Levin's Senate Permanent Subcommittee on Investigations. In 2011, there were at least 40 funds investing more than $55 billion in the commodities market versus 2008, when there were five funds with less than $10 billion in assets placed in commodities-related financial instruments.

According to exhibits prepared for that hearing, managers included some of the biggest names in the industry, such as the Pacific Investment Management Company, which has nearly $25 billion in the sector and Fidelity Investments with more than $7 billion.

Other big names cited include OppenheimerFunds, Goldman Sachs Group, Credit Suisse and BlackRock. Niche players include Equinox Fund Management and AQR Capital Management.

None of these companies are the subject of federal investigations or enforcement actions, nor have they been accused of any wrongdoing, related to this issue.

Mutual fund activity in commodities grew, in part, due to relaxed regulation by both the CFTC and IRS.

For example, in 2003, the CFTC decided to loosen its rules related to registration, marketing and trading.

Before that decision, Investment Company Act of 1940 firms had to do a lot to avoid registering as a commodity pool operator with the agency.

For instance, they had to prove that their commodity and alternative trading was meant for hedging and show that any non-hedge investments did not exceed 5% of the liquidated value of their assets. The 2003 CFTC amendments eliminated those requirements, leading to a rapid influx of assets. The February 2012 amendments essentially tried to close the floodgate and subject any funds investing in commodities to greater scrutiny.

The IRS loophole started in 2006, when the tax agency started writing ruling letters allowing funds to use two strategies to outmaneuver its 70-year-old Code Section 851(b)(2), which-in exchange for tax breaks-limits registered investment company stakes in commodities to be no more than 10% of total assets.

The first strategy to get around that requirement involves using controlled foreign corporations to trade in commodities, as Senator Levin and his fellow investigations subcommittee member Tom Coburn wrote in a December letter to IRS Commissioner Douglas Shulman.

With such companies set up, a fund would book any income generated from trades as coming from the securities held in these shell companies. The trading wouldn't count towards the cap, according to Levin and Coburn in their letter.

The second strategy, according to Levin and Coburn, would involve the issuing of "commodity-linked" notes, in which all activities tied to trading could be treated as processes related to securitization of commodities such as funding and sale of interest in these notes.

The IRS had written 72 such letters to mutual funds before suspending the practice in June. Senators Levin and Coburn are pushing the agency to make the suspension permanent.

"The IRS allowed mutual funds to establish wholly-owned controlled foreign corporations or CFCs whose sole function is to trade commodities in the futures and swaps markets,'' said Levin in a January hearing involving the letters. "In every case we've examined, mutual funds have established these CFCs as offshore shell corporations in the Cayman Islands, the classic example of a tax haven. The CFCs have no offices, no employees of their own, no independent business operations, and their commodity portfolios are run by employees who work in the United States for the mutual fund that set up the offshore arrangement.''

For example, he said, "one mutual fund told us all of the commodity investment decisions for their offshore corporation were made by the mutual fund's employees in Rockville, Md. Another told us all commodity trading decisions were made by their traders in New York.''

This shout-out is emblematic of the awkward situation mutual funds, and their regulators, face when it comes to investing in commodities.

Due to their structure and the 10% investment caps, these funds are forced to devise complicated strategies to invest in commodities, futures or options, if they want to use them to improve returns in funds that rely mainly on stocks or bonds.

Further, as entities largely supervised by the SEC, they've been able to stay off the radar of the CFTC and the industry's self-regulator, the NFA.

"There were regulatory lapses. Pot holes," says Ernest Badway, head of the white collar and securities industry practices at the New York-based law firm Fox Rothchild, who also has chaired the Securities & Exchange Committee of the New York County Law Association. "A lot of my hedge fund clients, my equity clients, they don't realize that the CFTC is going to follow them closely now.'"

The CFTC, as of yet, has taken no enforcement actions against mutual funds related to these matters. Indeed, many mutual funds participated actively in roundtables on the agency's rule amendments last summer.

Nonetheless, there is a tension that can be seen in critiques published by the NFA in 2010 of three non-CFTC registered mutual funds, including one marketed by Equinox Fund Management. Indeed these critiques, included in a June 2010 letter to the CFTC, helped spur the agency's process towards amending its rules.

Equinox executives did not respond to repeated requests for comment from Money Management Executive, by press time.

In the letter, the NFA found, for instance, that the prospectus materials of Equinox's MutualHedge Frontier Legends Fund omitted a number of disclosures, which the fund was allowed to do because of its exempted status.

Such omissions allegedly included details about who the futures commission merchants involved were and potential conflicts of interest. Also lacking was performance information on the funds operated by the investment advisor, according to the NFA.

An important point raised in the NFA letter was the fact that the Equinox fund is targeted at retail investors and marketed as commodity futures investment.

In the case of the MutualHedge Frontier Legends Fund, it is marketed as a "A Pioneering Managed Futures Investment" that is accessible, comprehensive and has proven management, according to the NFA.

The marketing material also describes it as having a "lower cost structure than most retail managed futures funds" and is the "first mutual fund to generate managed futures returns through net-long, actively managed CTAs," the NFA said.

A CTA is a commodity trading advisor, a trained expert employed by funds or sophisticated individual clients to invest in commodity instruments, who is licensed by the NFA and regulated by the CFTC.

As of Dec. 31, investors had placed $811.1 million into the Frontier Legends Fund, according to a client presentation by Equinox on its web site.

The investment fund is now described in Equinox documents as the "first managed futures mutual fund with an actively managed portfolio of CTA programs" that "seek to to generate returns using futures contracts on financial instruments, such as currencies, treasury bonds, equity indexes, and commodities such as corn, oil, gold and sugar.''

And the documents warn potential clients that "investments in commodities, futures, and managed futures are speculative, involve substantial risk, and are not suitable for all investors. Investors should be aware that such investments can quickly lead to large losses.''

Now such funds potentially face two masters: The SEC, under the Investment Company Act of 1940 and the Code of Federal Regulations, and the increasingly active CFTC. That could pose problems, if their agendas and requirements differ.

"Will the regulators continue to move in tandem or will their priorities be different?" asks Steven Gatti, a partner at the law firm Clifford Chance who heads its U.S. securities regulation practice. "The success, or otherwise, of these harmonizing efforts will be an important theme in this new regulatory environment for derivative products."

The CFTC aggressively ramped up its policing in 2011. The commission said it filed 99 enforcement actions against investment funds of various types, but not specifically mutual funds. That is up 74% from the previous year.

Gareth Old, a partner in the U.S. Derivatives and Regulatory group at Clifford Chance, said there will be "significant burdens on the managers of registered funds to make sure that their processes are aligned to what the CFTC is expecting.

"I think the CFTC may need to clarify what disclosures and what reporting they are looking for. Inevitably, the implementation is going to be a relatively slow process," he said.

At a minimum, there will be increased compliance controls and costs, said Susan Gault-Brown, a partner in the Washington-based law firm K&L Gates who specializes in investment management law.

She added that funds which currently use derivatives for hedging purposes or as a small part of their investment strategy may be able to continue to rely on what is left of the exemption, but will still have to build in compliance controls to make sure they stay within the rule's limits. Those that cannot will have to decide whether to change their portfolio holdings and investment strategies.

"The amended rule is likely to have a big impact on registered funds, particularly those with significant commodity strategies," said Gault-Brown.

Tommy Fernandez writes for Money Management Executive.