SEC Risk Alert - Registered Funds & ETFs

Disclaimer ("Fair Use"):  This blog should not be implied as an endorsement nor affiliation with the Securities Exchange Commission ("SEC") nor the Office of Compliance Inspections and Examinations.  This article is used for informational purposes only.

By David McNeal, Contributor of My Compliance Blog

November 21, 2018.  In this alert (released Nov 8th), The Office for Compliance Inspections and Examinations (" OCIE ") announced that it would implement a series of inspection initiatives focused on certain registered investment firms and exchange funds, the activities of their advisors and their supervisory boards.  

The alert specifies the following categories of focus: 

Index funds that track custom-built indexes  

A custom-built index is created or administered by a single fund or sponsors index provider. It is used to select the Fund's investments and can provide for a more complex or targeted investment strategy than the index funds traditionally have. 

  

Smaller ETFs and/or ETFs with little secondary market trading volume. 

Risks for investors include, for example, increases in bid / ask spreads and increases in premiums/discounts on the net asset value. These ETFs may also be exposed to the risk of being delisted from a stock exchange and having to liquidate their assets. 

  

Mutual funds with higher allocations to certain securitized assets. 

Investment funds that invest in certain securitized assets may expose retail investors to risks that may not be adequately disclosed to investors, or investment risks that the investment advisor does not expect in light of potential market conditions and unexpected market pressures. 

  

Funds with aberrational underperformance relative to their peer groups. 

Based on observations from prior examination efforts, the staff identified conflicts of interest associated with consultants who provide advice to both mutual and private funds, especially when managed by similar strategies or by the same portfolio managers, which could present specific risks to retail investors. 

  

Advisers relatively new to managing mutual funds. 

While advisors who are relatively new to the management of funds may not be new to the investment management industry, these companies may lack experience or knowledge about the Investment Company Act of 1940.   

Failure to provide adequate support for compliance increases the risk of failure to comply with specific regulatory requirements of the Fund, involvement in prohibited transactions or omission of information to be disclosed to the investors.  

Consultants who advise mutual funds and private funds with similar strategies or are managed by the same portfolio managers. 

The reviews will focus on the conditions under which retail investors may be disadvantaged and on whether registrants have fulfilled their regulatory and other legal obligations, and address the business practices, risks, and conflicts applicable to each topic.  

  

Index Funds that track custom-built indexes.  

The staff will assess the unique risks and challenges associated with the roles of advisors and index providers in selecting and weighting custom or custom-built index components, ongoing index management, fund management, and related performance advertising. During these examinations, the staff will also seek to: 

Compare the management of portfolios with the strategies outlined in the disclosures of funds. 

Understand the services of index providers and the completeness of that information provided to advisory boards. 

Assess whether conflicts of interest between index providers and advisors are adequately addressed. 

Review the effectiveness of the compliance programs of the Funds for portfolio management and the supervision of such programs by their boards. 

  

Smaller and/or thinly traded ETFs.  

Some of the compliance risks, conflicts, and practices the staff will assess include whether: 

Investment risks are adequately communicated to investors, including risks related to the liquidation of ETFs. 

Board supervision includes the ability of the ETF to continue as a constant concern. 

Tracking errors are monitored effectively. 

Portfolios are adequately liquidated for distribution on liquidation to shareholders. 

Delisting and associated liquidation procedures have been approved and supervised by the board, as applicable. 

  

Mutual funds with aberrational under performance relative to their peer groups. 

During the examinations, staff will assess whether the mutual funds’ and/or their advisers’ have appropriate: 

Policy, procedures and practices and related oversight, in particular, those related to portfolio management activities and investment risks. 

Portfolio management activities, including risk identification, monitoring, and mitigation practices to assess how advisors manage portfolio holdings and liquidity of mutual funds.  

Valuation and pricing policies and procedures that include understanding the pricing practices of mutual funds and the use of vendors, in particular concerning illiquid securities and other potentially tricky to value securities or asset classes.  

Governance and supervisory practices, especially with regard to pricing; and information on investors, especially with regard to investment risk.  

  

Side-by-side management of mutual funds and private funds. 

The staff will evaluate advisers’: 

Policies and procedures for dealing with conflicts of interest and other risks associated with side-by-side management, especially those related to certain portfolio management practices and portfolio development.  

Controls to ensure appropriate brokerage, best performance, and trade allocation practices, including the aggregation of trade and the allocation of investment opportunities per the fiduciary duty of the advisors.  

Assignment practices for different fees and expenses.  

Disclosures to boards of investors and funds.  

Funds managed by advisers that are relatively new to managing registered investment companies.  

The staff will evaluate: 

Governance of the Fund to ensure that boards have sufficient information to carry out their functions.  

Effectiveness of compliance programs for advisors and funds.  

Marketing efforts and distribution related to the funds. 

  

The purpose of this risk warning is to highlight the risks and problems identified by OCIE personnel. In addition to the risks described in this Risk Alert, other risks may be appropriate and some of the issues dealt with in this Risk Alert may not be relevant to a company's business. The suitability of monitoring, compliance and other risk management systems can be determined only from each company's profile and other facts and circumstances.  

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