The Securities and Exchange Commission wants mutual funds, exchange-traded funds and other registered investment companies to improve how they disclose their use of derivative contracts in their registration statements, shareholder reports and financial statements.

The recommendation comes in the wake of the SEC’s broader review of the use of derivatives by fund companies outlined in a March 25, 2010 statement. (The statement is available on http:/www.sec.gov/news/press/2010/2010-45.htm. Also, please see “Dodd Deals on Derivatives While Volcker Rule Fight Looms” and “Derivatives Useful Tool: McNabb,” MME 5/19/10 and 5/10/10).

In a July 30th letter to the Investment Company Institute, the regulator was critical of what it called generic disclosure which is either “highly abbreviated” or “lengthy, often technical.” The ICI’s members represent $11.42 billion in assets.

“These type of generic disclosures may not enable investors to distinguish which, if any, derivatives are, in fact, encompassed in the principal investment strategies of the fund or specific risk exposures they will entail,” wrote the SEC’s Office of Legal and Disclosure.

In the case of abbreviated disclosures, the SEC said that investors might erroneously believe that the fund’s exposure to derivatives is minimal, while in fact there may be “substantial exposure to derivatives-related risks.”

That is because the funds do cite the potential risks – correlation, counterparty, credit, leverage, liquidity, market and valuation – but the explanation of those risks is limited. Investors cannot tell, for one, if a fund’s use of derivatives is large or small. Such a technicality might lead investors to believe the fund has a “substantial exposure” to derivatives when its exposure is actually small.

That is because such disclosures are more tailored toward the specific type of derivative, but the complex and lengthy disclosure reduces its value for the investor.

The SEC urged mutual funds to tailor their disclosure to a fund’s economic exposure to derivatives and describe whether they are using derivatives for hedging or speculative purposes. The risk disclosure in the prospectus for each fund should provide an investor with a “complete risk profile” of the fund’s investments taken as a whole, rather than simply a list of the risks of various derivative strategies.

The regulator also wants mutual funds in the section on management discussion of fund performance (MDFP) in their annual reports to shareholders to address the impact of derivatives on investment performance. And the SEC wants mutual funds to disclose in their annual and semi-annual statements more qualitative information on the objectives and strategies for using derivative instruments as well as identify their counterparties.

“We have observed some funds that appear to have significant derivatives exposure in their financial statements, yet their MDFP includes limited or, in some cases, no discussion of the effect of those derivatives on the funds’ performance,” wrote the SEC. “We have observed some funds with MDFP derivatives-related disclosure that is solely forward looking and does not discuss the impact of derivatives on performance for the most recently completed fiscal year.”

According to the regulator, while many funds do state that they “may” engage in certain types of derivative transactions, they don’t provide qualitative information about how the funds achieved their objectives and strategies by using derivative instruments during the reporting period. While funds that sell protection through credit default swaps often include information on credit spreads as part of their disclosure, they don’t explain the importance of those spreads. In addition, not all funds reveal who their counterparties are in forward currency and swap contracts.

“Some of the generic disclosure has occurred because mutual funds have been uncertain about the disclosure required,” said Todd Cipperman, president of Cipperman & Co., a law firm in Wayne, Pa., in a communiqué with clients today. This letter to the ICI certainly helps.”

Cipperman, whose law firm specializes in investment funds, also recommended that the SEC consider an amendment to Form N-1A requiring the improved disclosure.

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