March 24, 2016
I am a lead advisor and part-owner of a registered investment advisor in Sandy Springs, Georgia that manages over $200 million in client assets for approximately 200 clients. I have been in the financial services industry for nearly 20 years, having completed designations such as the Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP) in the process.
My purpose in writing this letter is to express frustration with your proposed new rule on "Use of Derivatives by Registered Investment Companies and Business Development Companies." I believe that the rule, as written, would dramatically limit the ability of investors - at least those investors without millions of dollars and resultant access to less regulated vehicles - to properly diversify.
As you know, the concept of "Modern Portfolio Theory" (MPT) pioneered by Harry Markowitz led to Markowitz being honored with an eventual Nobel Prize. While MPT has its practical limitations and is certainly open to criticism, the central idea is that diversification helps to reduce risk for a given level of expected return. My explanation of investing to individual clients starts with this concept - the idea that diversification provides the one free lunch of finance and that any time there is a free lunch, we want as much as we can get.
In order to achieve true diversification and not just a big collection of assets that all behave the same, we utilize alternative investment mutual funds. In fact, I have been employing strategies such as "managed futures" and "alternative beta" for my entire professional career in order to achieve returns that are uncorrelated with traditional stocks and bonds. The proliferation of 1940 Act mutual funds offering these strategies over the past 5-10 years has made it cheaper and easier for my clients to gain this valuable diversification.
My concern is that the new rule would place unreasonable restrictions on the use of derivatives by mutual funds, especially the liquid alternative mutual funds that are so valuable to properly diversifying. While there are assuredly funds that misuse derivatives and managers that take excessive risk through derivatives, I do not think the answer is simply to restrict usage of all derivatives.
The current rule entirely ignores the risk level of various derivative contracts and treats them as a single dangerous investment. It treats a US Treasury futures contract and a low grade emerging market credit default swap as having the same risk level, despite the fact that the risk of these investments could not be more different. It seems more reasonable and prudent to design a rule that differentiates between appropriate and inappropriate uses of derivatives rather than just to say all derivatives are bad and investors should not be using them. This approach of blindly throwing all derivative contracts into a single bucket unfairly penalizes investors. The current rule, if implemented without change, is likely to force many well-intentioned alternative funds that use derivatives to close or dramatically change the way they operate to the detriment of my clients.
I applaud the SEC's intentions and believe that there is a need to regulate the improper use of derivatives. However, I think there is a better answer and I would encourage you to consider some form of risk-adjustment in the rule that appropriately differentiates risk so that advisors like me can still properly diversify client portfolios.
Thanks for considering my request.
Jason Lina, CFA, CFP
Lead Advisor, Resource Planning Group