Mutual Funds - The Next 75 Years
Commissioner Kara M. Stein
Brookings Institution, Washington, D.C.
June 15, 2015
Thank you, Doug, for that kind introduction.
Before I begin my remarks, I must make the standard disclaimer you hear from SEC Commissioners: the views that I am expressing today are my own, and do not necessarily reflect those of the Commission, my fellow Commissioners, or the staff of the Commission.
I am very pleased to be at the Brookings Institution this morning. Brookings has a long and proud history of tackling difficult public policy issues and fostering robust public debate. Recent discussions on the role of capital markets in today’s economy and systemic risk in the asset management industry are important contributions to the national dialogue. So, thank you to the Brookings Institution for continuing to drive important conversations. And thank you for having me here today.
This year marks the 75th anniversary of the Investment Company Act of 1940 (the “Investment Company Act”), which established the regulatory framework for registered investment companies, or registered funds, in the United States. This anniversary may not mean all that much to those of you who aren’t securities regulators, but this law has touched almost everyone in this room in some way. Most Americans know registered funds as mutual funds, or perhaps as exchange traded funds (ETFs). Nearly one out of three Americans - over 90 million people - put their investment dollars to work in such registered funds.
These funds play an absolutely vital role in the ability of many Americans to retire. This role is likely only to increase in the coming years. In order to put some context around why registered funds matter so much going forward, I want to briefly discuss some recent census figures. As most of us know, over the next 35 years our country’s senior population is expected to swell. Recent government figures estimate that roughly 15% of the total population is age 65 or over, or approximately 46 million Americans. By the year 2050, there are projected to be nearly 88 million Americans age 65 and over, which is roughly 22% of the total projected population. So, in the next 35 years we are expecting a 7% increase in the number of older Americans. That’s a big shift.
This expansion in the number of Americans age 65 and over coincides with Americans needing to take more and more responsibility for their golden years. For much of the last century, people have thought of retirement as a stable “three-legged stool” – Social Security, a pension, and personal savings. However, for many families, at least one leg of the stool has disappeared – the pension. And the other two legs have become a bit more wobbly. Former SEC Chairman Arthur Levitt noted back in 1998 that “an era of self-reliance has begun” with respect to retirement planning. It has only accelerated in the direction of self-help since 1998.
In 2015, Americans expect less and less of their retirement income to come from Social Security and employer-sponsored pensions, and more and more of it to come from personal investments. Most Americans will make such investments through mutual funds and ETFs. And given current projections, an ever-increasing number of Americans will be relying on these funds for their retirement.
Most of you are probably somewhat familiar with how mutual funds and ETFs operate. But as a quick refresher – a fund will generally pool money from thousands of shareholders who have purchased interests in the fund. An asset manager then invests this pool of money in stocks, bonds, and various other financial instruments. The fund’s shareholders share proportionally in the fund’s profits, but they also share proportionally in the losses. The asset manager directing the investments is, of course, compensated for its work, usually through a management fee.
Since 1940, the American mutual fund and ETF market has become the largest in the world. It had approximately $18 trillion in assets under management at the end of 2014 – which is more than 50% of the worldwide market. If you have a 401k plan for your retirement savings or a 529 plan for a child’s college education, you likely are an investor in a registered fund. Whether it is for retirement, college, a future home purchase, or anything in between, Americans rely on investment companies now more than ever.
The use of these investment vehicles or registered funds is especially pronounced for retail investors. Most retail investors that want to invest in stocks and bonds do so through a mutual fund or ETF. By retail investor, I mean the everyday citizen or household that is investing – not institutional investors or pension funds. Eighty-nine percent of mutual fund assets are attributable to retail investors.
So, as we note the 75th anniversary of the Investment Company Act, we also should acknowledge that the funds that are organized under the Act have never played a more important role in our country or our economy. And, as the census numbers indicate, this role is likely to grow.
The 75th anniversary of the Investment Company Act happens to coincide with a major rulemaking initiative by the Securities and Exchange Commission to update and modernize some of the rules having to do with registered funds. The Commission recently proposed new rules that will enhance and improve the data that registered funds report to the Commission and to the public. The staff is also examining making potential changes to liquidity management rules and rules regarding the use of derivatives by registered funds. All of this comes against the backdrop of the Financial Stability Oversight Council (FSOC) and others taking a closer look at the potential systemic risks posed by asset managers and registered funds. So, this anniversary of the Investment Company Act seems like a particularly appropriate time to reassess our regulatory framework under the Investment Company Act, address new and emerging risks, have a dialogue with the asset management industry, and fortify our commitment to investor protection going forward. Ultimately, all stakeholders involved want the same thing – 75 more years of stable growth and success.
This morning, I thought I would share some thoughts regarding asset managers, registered funds, and registered fund investors. First, I always find it helpful to start with some historical perspective. What was the impetus for the Investment Company Act and why do we have it?
Second, is the Investment Company Act still working? The Act was built on a sturdy foundation of strong rules that have served funds and their investors well for 75 years. Constants such as liquidity requirements and leverage limitations have been cornerstones in this foundation. However, we may need to consider whether certain cornerstones are still working or whether they may need repairs.
Finally, I will offer some thoughts about alternative mutual funds. These funds often operate in a gray area of mutual fund regulation. Most would not have envisioned these funds taking off even a couple of decades ago. I think that we all need to be asking questions about the development of these funds and what they mean to the retail investor. Do investors understand these products? Are these funds adhering to the foundational principles of the Investment Company Act, which have served investors so well for 75 years?
History of the Investment Company Act
So let’s start with a bit of history. Prior to the Investment Company Act being adopted in 1940, investment funds were essentially only subject to a disclosure regime. There were few hard and fast rules for funds to follow. So long as funds generally disclosed their practices and risks, they were considered compliant with the law. Congress recognized this was problematic and decided to target, through the Investment Company Act, “abuses which may grow out of the unregulated power of management to use large pools of cash.”
In the run up to the 1929 Crash, investment companies and investment trusts had proliferated. Many of them had high degrees of leverage. The historian John Kenneth Galbraith noted that these vehicles were “greatly admired marvels of the time.” Unfortunately, these marvels were rife with abuse. A Securities and Exchange Commission study around that time noted that these investment companies were often receptacles for the unloading of worthless securities. Many investment companies were operated primarily to advance the interests of management, without any care for the interests of investors. The same study noted that investment companies were often organized so that promoters could sell the securities door to door like salesmen, regardless of the soundness of the investment.
United States Senator Robert Wagner of New York noted in hearings in 1940 that investment companies were still in their infancy at the time of the Crash, and that the industry was not immune to the issues facing the broader marketplace.
Interestingly, the approach adopted in the Investment Company Act clearly recognized that disclosure alone was not sufficient. In order to protect investors in these funds, Congress determined that substantive regulation with strong, predictable minimum standards was necessary. Funds needed to be straightforward and predictable enough so that the average investor knew what he or she was getting into. As Senator Wagner noted at that time, the “important thing is that the individual … should know what type of investment he is making.”
Commissioner Robert Healy, who was part of the first Securities and Exchange Commission, reinforced this point in his testimony before the Senate in 1940. He stated:
It should hardly be necessary to point out that existing legislation is not adequate to meet the problems presented by the investment company…The disclosure principle embodied in the Securities Act and the Securities Exchange Act is a sound principle, but it has its limitations.
He also noted that:
There are certain practices that have happened in connection with investment companies that I think everybody agrees…ought to be stopped, and they cannot be stopped by mere disclosure.
It is also important to note that the registered fund regime is not meant to mirror the private fund world, to which it is often compared. These are two very different forms of investment. Private funds, like hedge funds, operate more on a disclosure basis. They receive certain exemptions as long as only a certain category of investors is involved. They are allowed substantial leeway and are generally not subject to the same substantive rules as registered funds, so long as all material terms of the investment are disclosed. This flexibility is justified, at least in part, by the fact that investors in private funds have to meet certain wealth requirements and tend to be more sophisticated. Mutual funds, conversely, are invested in by everyday retail investors. Because of this investor base, Congress mandated that the Investment Company Act have strong and clear rules to protect these investors, in addition to robust disclosure.
In many ways, the Investment Company Act of 1940 has remained a prescriptive statute with strong rules and robust disclosures. The retail investor still knows exactly what to expect from a mutual fund in many areas, including requirements that major fund contracts be approved, and that there be no affiliated transactions. The Investment Company Act’s restriction on affiliated transactions is a great example of substantive regulation that has withstood the test of time. It is worth spending a little time on this particular concept because I think it illustrates how the Investment Company Act is supposed to function, by setting clear and dependable rules that protect retail investors.
The Investment Company Act itself strictly limits affiliated transactions between funds and their affiliates. This means that the people running the fund cannot use the fund to benefit themselves at the expense of fund shareholders. It basically protects against conflicts of interests. Registered funds cannot simply disclose these conflicts of interest away, as a private fund might. As the SEC’s Division of Investment Management’s 1992 study on registered funds noted:
The Investment Company Act's provisions concerning affiliated transactions are at its heart. The provisions were intended to go beyond those provided under common law, which allows fiduciaries to deal with their beneficiaries if adequate disclosure is made.
Maintaining bright line rules on affiliated transactions makes perfect sense and is incredibly valuable. This clear, bright line rule gives retail investors predictability and consistency when investing in mutual funds.
Drift from First Principles
This commitment to clear, dependable disclosure and basic bright line protections for investors is largely responsible for the 75-year-old success story of mutual funds. As the registered fund industry continues to evolve and play an increasingly large role in our economy, I think that we need to remember that a strong legal framework enabled this growth. Having said that, I am concerned that we are starting to see some cracks in the foundation of this framework that we should all be thinking about.
In some ways, it appears that registered funds have slowly drifted toward a more flexible and permissive disclosure regime. This drift increasingly places the onus on the retail investor to figure out whether a fund is right for him or her. And the retail investor, who generally tends to be less sophisticated in financial matters, might not even understand what he or she needs to know to make that decision.
For example, the liquidity of registered funds is one area where it seems that regulation has drifted into “buyer beware.” A retail investor looks at a mutual fund and expects that he or she will be able to get money out of a fund very quickly if needed. A retail investor is generally not performing cash flow analyses on mutual funds to test their true liquidity.
This expectation comes from the Investment Company Act of 1940, which requires mutual funds to honor redemption requests within seven days of a shareholder request. In practice, as many of you have probably experienced, the redemption occurs much more quickly than that. In addition, Commission guidance only allows mutual funds to invest up to 15% of the fund’s assets in illiquid securities. As a result of both of these requirements, retail investors assume that their investments in registered funds are fairly liquid and can be redeemed quickly if need be. This liquidity profile has been a foundational principle of the Investment Company Act since its inception.
But, I am concerned that this assumption now may be misplaced given some of the new, complicated registered funds that have entered the marketplace. For example, registered funds that invest in bank loans have become popular. Since late 2009, assets in bank loan mutual funds and ETFs have increased by almost 400%. Yet, many of the underlying loans in these funds may take over a month to actually settle. If it takes over a month to settle, it is reasonable to wonder how the fund could possibly meet the seven day redemption requirement in the Investment Company Act in times of market stress.
Additionally, these bank loan funds may be comprised almost entirely of illiquid bank loans, which would seemingly violate the 15% threshold. Some may also invest in collateralized loan obligations (CLOs). How is this happening? Funds have relied on an interpretation that allows them, for example, to base the 15% standard on when a contract price is struck to sell the underlying bank loan and not on when actual settlement of the loan occurs, which is when the fund would actually receive cash and transfer ownership of the loan. Unfortunately, I am not sure that retail investors have received the memo that interpretations of liquidity rules have changed beneath their feet for certain funds. Not only that, retail investors may not even receive disclosure about risks related to this extended settlement period. Over time, this 15% liquidity standard has arguably become more of a compliance exercise than a true restriction.
Bank loan funds are just one example of new types of funds that may require further examination as we consider updating our liquidity rules. A prominent investor recently remarked: “It’s one of my standing rules that no investment vehicle should promise greater liquidity than is afforded by its underlying assets.” I fear that is precisely what is happening with some of the new types of funds that are entering the marketplace. Promising high liquidity, which all mutual funds must do, on illiquid assets, that have not traditionally been a part of mutual funds, does not seem in keeping with the intent of the Investment Company Act.
I hope that as the Commission considers action in the area of liquidity, it asks hard questions about new and innovative products, as well as emerging risks. Do the retail investors investing in these funds truly understand and appreciate the liquidity of the fund? Perhaps these investments make sense for a private fund, which has a more sophisticated investor base and is often subject to lockups and gates that can help the fund navigate market stress. But what happens to an open end mutual fund or ETF – which must honor redemptions in seven days – when financial conditions get rocky, redemption requests surge, and the fund is primarily invested in illiquid assets?
Another cornerstone principle in mutual fund regulation has been the requirement for relatively low leverage, as mandated by Section 18 of the Investment Company Act. Section 18 generally limits the ability of funds to leverage their assets through the issuance of “senior securities,” such as derivatives.
In addition, a registered fund generally must maintain 300% asset coverage for senior securities. This 3:1 coverage ratio is in line with what investors have thought about mutual funds for decades – namely, that they are not highly leveraged vehicles. There is also an expectation that embedded leverage obtained through derivatives is low. Commission officials have pointed out over the years that “Congress was concerned that abuses could result when funds leveraged without any significant limitations.” The protections of Section 18 of the Act are meant to be substantive and real, not aspirational.
Unfortunately, this cornerstone principle appears to have gradually eroded as well. Derivatives usage by registered funds has skyrocketed in the past couple of decades. Without getting too far into the minutia, the Commission issued guidance back in 1979, and the Commission staff have issued almost 30 no action letters, all on the issue of leverage obtained through derivatives. The result has been a mixed bag, a patchwork of regulation that does not always comport with Section 18. This ad hoc approach has chipped away at a true leverage restriction. There have been reports of funds being able to obtain notional exposure of up to 10 times the fund’s net asset value through instruments like swaps and futures. I think that most would agree that this type of leverage runs counter to the leverage limitations required by Section 18 of the Investment Company Act.
I am very pleased to see that the Commission is considering taking up this issue as well. It’s difficult and complex, but we need to tackle it. It was always intended that leverage be limited under the Investment Company Act. As I mentioned earlier, many of the early investment companies and investment trusts that imploded in the 1920’s were highly levered vehicles. When earnings and values fell, leverage exacerbated the problems in these funds. This might sound eerily familiar to those of us who recently went through the recent financial crisis. Going forward, the Commission’s approach must reflect the Investment Company Act’s foundational principle that leverage be limited in registered funds.
Alternative mutual funds and retail investors
Liquidity, leverage, derivatives, and investor protection are also elements that should be present in any discussion about alternative mutual funds. It is hard to define what an alternative mutual fund is. It can mean different things to different people. But, generally, they are mutual funds or ETFs that pursue an investment strategy in a non-traditional asset class, use non-traditional investment strategies, and/or invest in illiquid assets. They also frequently seem to rely on derivatives for their investment returns.
Assets under management in alternative mutual funds have exploded in recent years. In 2008, there were approximately $46 billion in assets under management for these funds. By the end of 2014, the number had surged to over $311 billion in assets under management. This is an increase of over 575%. We continue to see more investment firms pressing to move into this area. An official at the Commission had an interesting description for alternative mutual funds. He called them “bright, new, shiny objects in the marketplace that are also very sharp and fraught with risk.”
Going back to my original theme, it is worth thinking about whether these alternative mutual funds have gradually drifted away from the intent and foundational principles of the Investment Company Act. For a long time, mutual fund managers did not suggest that they could manage a fund in a way that mimicked the return of a top hedge fund. It was simply understood that the liquidity and leverage restrictions contained in the Investment Company Act were prohibitive, and would not allow for a true hedge fund type strategy. If you wanted the potential upside that a hedge fund strategy might give you, you had to accept the downside of a certain level of illiquidity with your investment, which you could not do within a registered fund.
Yet, today, alternative mutual funds promising the upside of hedge fund investments with the liquidity of traditional mutual funds are all the rage. I think that this trend should give everyone pause, and regulators and the public need to be asking questions about this development. Many of these funds may indeed be innovative. But are they consistent with the Investment Company Act and its protection of the retail investor, particularly leverage restrictions? What should the regulatory reaction be? Should we consider regulating these funds differently than plain vanilla, traditional mutual funds?
As I have laid out, the retail investor has certain expectations of mutual funds, grounded in longstanding rules under the Investment Company Act. Alternative mutual funds seem to operate on the margins of several of these rules. They may be less liquid, employ more leverage, and invest in exotic and complex instruments. At a minimum, this raises the question of retail investor confusion. Do retail investors understand that the unconstrained alternative bond fund that they are being sold may not actually perform like a traditional bond fund at all? What happens during the next crisis, when markets are stressed and alternative mutual funds are tested for the first time? All of these questions should be asked and debated now, and not during a time of financial market distress.
As I mentioned earlier, the Commission is at the beginning stages of a rules initiative focused on asset managers and registered funds. In particular, the Commission and staff will be considering liquidity and derivatives. This initiative presents a much needed opportunity to take a holistic look at how the Investment Company Act is currently functioning and if it can be enhanced and updated going forward.
I strongly believe that we need to keep in mind what is happening on a macro level. Most people are living paycheck to paycheck. Yet, we are asking them to take more and more responsibility for saving for their retirement. Americans will be looking to mutual funds and ETFs to help them do this. Given this reality, regulators and the industry have a responsibility to make certain that the legal framework is stable and remains focused on protecting the retail investor.
Investment Company Act regulation is not one size fits all. That has been one of its strengths. There has been flexibility in the Investment Company Act through the use of exemptive orders and other relief. This flexibility has allowed fund companies to continue to evolve, innovate, and develop new investment opportunities. That is healthy.
However, mutual funds have become one of America’s most successful industries for a very good reason. The Investment Company Act is a shining example of smart, investor-centric regulation. For decades, there has been tremendous value in the fact that shareholders generally know what to expect structurally from a mutual fund. Retail investors have not had to have a graduate degree in finance to figure out what a mutual fund’s liquidity or leverage really is. Mutual funds have allowed investors to take informed risks within a well understood set of basic restrictions and protections.
I encourage all of you — whether you are an academic, an attorney, a fund representative, or an interested investor— to help the Commission as it moves forward on updating some of our rules for asset managers and registered funds. Your participation in the notice and comment rulemaking process is very important. We need to hear from as many perspectives as possible. It truly informs our rules and allows us to make good policy decisions.
I look forward to continuing to work with all of you on these challenging issues. I am pleased that the Brookings Institution has been a facilitator of and participant in these discussions – and I know that it will continue to play this important role. Thank you very much for your time this morning, and thank you again to the Brookings Institution for inviting me to speak with you.
 Investment Company Act of 1940, 15 U.S.C. §§ 80a-1–64 (1940).
 See Sandra L. Colby and Jennifer M. Ortman, Projections of the Size and Composition of the U.S. Population: 2014 to 2060 (March 2015), available at https://www.census.gov/content/dam/Census/library/publications/2015/demo/p25-1143.pdf.
 See id.
 See Chairman Arthur Levitt, The SEC Perspective on Investing Social Security in the Stock Market, October 19, 1998, available at https://www.sec.gov/news/speech/speecharchive/1998/spch223.htm.
 See Work in Retirement: Myths and Motivations, a Merrill Lynch Retirement Study, available at http://www.ml.com/publish/content/application/pdf/GWMOL/MLWM_Work-in-Retirement_2014.pdf.
 See ICI 2015 Fact Book.
 See id.
 See Chair Mary Jo White, Enhancing Risk Monitoring and Regulatory Safeguards for the Asset Management Industry, December 11, 2014, available at http://www.sec.gov/News/Speech/Detail/Speech/1370543677722.
 See Investment Company Reporting Modernization, Investment Co. Release 31610 (May 20, 2015), available at https://www.sec.gov/rules/proposed/2015/33-9776.pdf.
 See SEC v. Fifth Avenue Coach Lines, Inc., 289 F. Supp. 3 (S.D.N.Y. 1968).
 See John Kenneth Galbraith, The 1929 Parallel (“Galbraith”), January 1987, available at http://www.theatlantic.com/magazine/archive/1987/01/the-1929-parallel/304903/.
 See id.
 See Statement of Commissioner Robert E. Healy before Subcommittee on Banking and Currency (“Healy Statement”), April 2, 1940, available at https://www.sec.gov/news/speech/1940/040240healy.pdf.
 See Id.
 See Investment Trusts and Investment Companies: Hearings before a Subcommittee of the Committee on Banking and Currency, 67th Cong. 339 (1940).
 Investment Trusts and Investment Companies: Hearings before a Subcommittee of the Committee on Banking and Currency, 67th Cong. 333 at 564 (1940).
 See Healy Statement.
 See Statement of Commissioner Robert E. Healy, Investment Trusts and Investment Companies: Hearings on H.R. 10065 before a Subcommittee of the House Committee on Interstate and Foreign Commerce, 67th Cong., 3d Sess. 64 (1940).
 See Section 15(c) of the Investment Company Act.
 See Section 17 of the Investment Company Act.
 See Protecting Investors: A Half Century of Investment Company Regulation, Division of Investment Management (May 1992) at p.483, available at https://www.sec.gov/divisions/investment/guidance/icreg50-92.pdf.
 See Section 22(e) of the Investment Company Act.
 See Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18612 (March 12, 1992).
 Based on Morningstar Direct data as of May 19, 2015.
 The Investment Company Institute (ICI) has expressed the view that, rather than requiring the settlement of a sales transaction within seven days, the Commission's liquidity standard requires only that a contract price be struck. See Investment Company Institute, Valuation and Liquidity Issues for Mutual Funds (1997).
 See Howard Marks, Memo to Oaktree Clients from Howard Marks Regarding Liquidity, March 25, 2015, available at http://www.oaktreecapital.com/memotree/liquidity.pdf.
 See Andrew J. Donohue, Investment Company Act of 1940: Regulatory Gap between Paradigm and Reality, April 17, 2009, available at https://www.sec.gov/news/speech/2009/spch041709ajd.htm.
 See Use of Derivatives by Investment Companies under the Investment Company Act of 1940, Investment Company Act Release No. 29776 (August 31, 2011), available at http://www.sec.gov/rules/concept/2011/ic-29776.pdf.
 See Securities Trading Practices of Registered Investment Companies, Investment Company Act Release No. 10666 (April 18, 1979).
 See David Grim, Remarks to PLI Investment Management Institute 2015, March 5, 2015, available at https://www.sec.gov/news/speech/remarks-pli-investment-management-institute-2015.html.
 See Galbraith.
 Based on Morningstar Direct data as of March 16, 2015.
 See Andrew J. Bowden, People Handling Other Peoples’ Money, March 6, 2014, available at http://www.sec.gov/News/Speech/Detail/Speech/1370541260300.
 See Rob Copeland, Can Hot New Bond Funds Burn You, Wall St. Journal, April 6, 2015, available at http://www.wsj.com/articles/the-success-and-dangers-of-liquid-alternative-mutual-funds-1428375823; see also Sabrina Wilmer and Margaret Collins, Private Equity Billionaire Is Now Selling a Hedge Fund for the Masses, Bloomberg, April 7, 2015, available at http://www.bloomberg.com/news/articles/2015-04-07/bonderman-s-wildcat-family-office-backing-hedge-fund-for-masses.
 See Joshua Brown, The Biggest Mistake Investors Are Making Right Now, Fortune, March 25, 2015, available at http://fortune.com/2015/03/25/unconstrained-bond-funds-risk/.