Alternative Investment Techniques in Registered Funds

Transcription

1 MUTUAL FUND DIRECTORS FORUM AND COLUMBIA UNIVERSITY Funds Use of Derivatives November 8, 2007 Alternative Investment Techniques in Registered Funds Susan C. Ervin Dechert LLP Washington, DC Dechert LLP

2 Hedge Fund vs. Mutual Fund Dichotomy Conventional wisdom that registered investment companies cannot engage in typical hedge fund strategies Market has overtaken conventional wisdom Hybrid mutual funds rely significantly on derivatives transactions 2

3 Why Can t a Mutual Fund Use Hedge Fund Strategies? The Usual Suspects: Section 18(f) senior security prohibition constrains use of leverage Fund policies limit use of derivatives Liquidity issues Good income issues under IRC Subchapter M 3

4 Dimensions of a Derivative Issue 1. Defining the Product names rule investment policies disclosure diversification 12(d)(3) Alternatives Issuer or reference asset? 2. Leverage/Value names rule senior security cover qualifying income diversification Liquidity Notional value or market exposure? 4

5 Dimensions of a Derivative (cont d) Issue 3. Security/Securities-Related or Non-Security Subchapter M good income Alternatives 1940 Act definition Internal Revenue Code definition 1933/34 Act definitions 4. Trading Conditions liquidity valuation Exchange-traded vs. OTC (overthe-counter) 5

6 Commodity Investments Futures Contract Key Exposure Element Underlying asset Value/ Leverage Cash-settled: MTM Other: notional value Qualifying Income If underlying is securities-related/ FX Forward Underlying asset TBD If underlying is securities-related/ FX Swap Underlying asset Market exposure If underlying is securities-related/ FX Structured Note Issuer and underlying asset Trading Conditions Liquid Market Contract- Determined Contract- Determined Not leveraged Yes Variable Common Stock of Commodity Company Issuer Not leveraged Yes Variable 6

7 Examples of Hedge Fund Strategies Commodity exposure 10% cash equivalents 90% commodity exposure Long/Short 50% Long securities 50% Short securities Portable Alpha 25% broad market index 75% active management through swaps, securities, etc. 7

8 Commodity Focus Objective 90% of assets for commodity exposure: Wash. DC housing price index 10% of assets in cash/cash equivalents Futures Contracts Obtain commodity exposure through commodity futures Senior security asset cover Notional = $250 x 230 = 57,500 Market value: daily gain/loss Cover amount = approx. $300,000 on market value basis Qualifying income Structured Note Commodity exposure; issuer exposure Not a senior security Can be structured to produce qualifying income Liquidity depends on note terms Not securities-related income if non-securities/fx reference asset Liquid 8

9 Long/Short Strategy Market Neutral 50% Long Positions 50% Short Positions Equity Swap Short equity exposure (pay floating equity, receive fixed rate) Senior security cover: mark-to-market exposure Qualifying income: yes Liquidity by contract Short Sale Short equity exposure Senior security cover current market value of security, less margins on deposit Qualifying income: yes Liquidity: yes, depending on contract 9

10 Portable Alpha Strategy Broad Market Exposure Actively Managed Portfolio Desired Market Exposure -- $10,000,000 CME S&P 500 futures contract ($250 x 1,400 [index value] = $350,000 notional amount Cover amount = approx. $500,000 on market value basis Desired Active Management Portfolio -- $8 Million Cash Cushion -- $1.5 million 10

11 Conclusion: Hedge Fund/Mutual Fund Tradeoffs Investment flexibility vs. disclosure/transparency, liquidity, safety cushion Unfettered innovation, access to newest strategies vs. regulation/oversight, compliance infrastructure, product constraints Unintended consequence: 1940 Act and IRC bias toward securities and securities-related products can reduce access to full array of diversification strategies, new products and unconventional product designs 11