Todd Cipperman is the founder of Cipperman Compliance Services, which provides compliance consulting to funds, advisors, and broker-dealers. In a Q&A with Money Management Executive, he speaks about FINRA's impact on mutual fund and ETF managers and the regulatory body's influence on alternatives and closed-end funds.

FINRA defines alternative mutual funds as any registered fund with a non-traditional investment or trading strategy including fund-of-funds, hedging, derivatives, long/short, opportunistic and absolute return. The regulator has warned that alt funds may be less transparent, carry additional risk, impose higher fees, utilize inexperienced managers and have limited performance histories. What's your take?

FINRA states, "There may be other investment options to alt mutual funds that are less complicated and cost less, but still help you accomplish your financial objectives." FINRA does acknowledge that such funds are more regulated than traditional hedge funds, thereby offering more liquidity, reduced leverage, more diversification, and daily pricing. My take: FINRA is painting with a pretty wide brush. We don't see the commonality between an absolute return fund-of-funds and a single strategy derivatives product. Also, when FINRA looks at risk, it ignores factors such as volatility and various other risk measures utilized by investment professionals.

You've said that FINRA "continues its assault on alternatives." What is your perspective on alts in general?

Some alts are risky (volatile); some are designed to be anti-risk (less volatile). Alts is really a non-descriptive pronoun for a wide variety of investments: hedge funds (of many stripes), private equity funds, venture funds, REITs, natural resource funds, MLPs, etc. I think regulators should stop using the "alts" moniker for every investment that is not a mutual fund, ETF, or portfolio of publicly traded securities.

How do alts play a role for mutual fund/ETF managers?

I have seen many mutual fund and ETF managers use various instruments for risk management and return enhancement. However, the Investment Company Act significantly limits open-end funds and ETFs from investing in derivatives, private vehicles, illiquid securities and other funds.

FINRA has issued an investor alert warning closed-end investors that distributions may come from a return of principal or capital rather than dividends, interest, or capital gain. How does this impact mutual fund/ETF providers?

In many ways, such an alert helps level the playing field for mutual funds and ETFs. Some closed-end funds advertise their consistency against mutual funds and ETFs by highlighting managed distributions that look more stable than mutual funds and ETFs, whose distributions depend more directly on market forces. This alert suggests that investors should not be fooled by this consistency because some closed-end fund sponsors simply return principal in order to deliver these consistent distributions. Consistent dividends should not be equated with lesser volatility.

FINRA also cautions investors that closed-end funds are allowed to hold more illiquid investments than open-end funds. Do you believe this caution is warranted? Why or why not?

This is absolutely true. One of the main reasons for structuring an investment vehicle as a closed-end fund is to allow the vehicle to hold illiquid investments. If a fund held liquid investments (able to be liquidated within seven days), it would make more marketing sense to structure it as an open-end fund. However, the Investment Company Act and the tax code require open-end funds to make specified distributions. Closed-end funds holding illiquid securities cannot comply with these rules.

What are the top regulatory challenges that money managers (mutual funds/ETF managers) face? What type of compliance challenges do they face?

That question will depend on the type of manager. Bond managers, for example, will continue to struggle with valuation processes and procedures. For money market managers, both the Financial Stability Oversight Council and the SEC want so much regulation that the product may become obsolete. And, equity managers keep pushing against regulatory limitations on portfolio investments so as to compete with ETFs and hedge funds. All funds face an SEC intent on scrutinizing processes and compliance programs.

FINRA has warned investors about alt funds but you don't see the commonality between an absolute return fund-of-funds and a single strategy derivatives product. Why is this?

FINRA, the SEC and private industry face the same challenges when looking for talent. There are simply not enough candidates with the necessary industry, product and regulatory knowledge. So, organizations have to turn to internal training. This takes time. The regulators have a more difficult problem because trained personnel tend to leave for private industry positions paying more money. While we all get frustrated with examiners that don't understand the industry, I have a great deal of sympathy for the people that run FINRA and the SEC because they are severely limited in their ability to hire and retain talent.

Why do you believe FINRA ignores factors such as volatility and various other risk measures when evaluating alts?

I don't think they ignore it. I just think that the regulators view their constituency as the archetypical "mom and pop" investor. In this regard, it is safer to warn against all alternatives rather than explain (or regulate) the nuances of each.

The financial meltdown created a higher focus on risk management among mutual funds and ETFs. In your view, how did 2008 influence how FINRA approaches mutual funds and ETFs, and has the result been positive?

I don't think the credit crisis had as much of an impact on the regulators as the Madoff scandal. Both the SEC and FINRA were heavily criticized for failing to uncover the Madoff fraud. I actually don't blame either, and I think the regulators took a lot of unwarranted heat. Regardless, the political pressure on the SEC and FINRA transformed both regulators into organizations with something to prove to Congress and the public. As a result, they have increased resources and focused on enforcement actions and penalties, rather than supervising and regulating. a result, firms are spending more on compliance. 

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