Commission Issues Guidance to Investment Companies on Derivatives-Related Disclosure

This story appeared in SEC Today.

In a July 30 letter to the Investment Company Institute, the staff of the SEC’s Division of Investment Management provided guidance on derivatives-related disclosure by investment companies in registration statements and shareholder reports (SEC No-Action Letters Ind. & Summaries (WSB) #0802201002 (July 30, 2010)).  The guidance resulted from the staff’s ongoing review of the use of derivatives by mutual funds, exchange-traded funds and other investment companies.  The staff decided to share its observations prior to completion of the review in order to give investment companies immediate guidance on providing more understandable disclosure on derivatives, including their risks.

The staff noted that it has seen derivatives-related disclosures by some funds that it believes is not consistent with the intent of Form N-1A’s requirements. In particular, some funds provide generic disclosures about derivatives that, in the staff’s view, may be of limited use to investors in evaluating the anticipated investment operations of the fund, including how the fund’s investment adviser intends to manage the fund’s portfolio and the sequent risks.

The staff said that the generic disclosures vary from highly abbreviated disclosures that briefly identify a variety of derivative products or strategies, to lengthy, highly technical disclosures that detail a wide variety of potential derivative transactions without explaining the relevance to the fund’s investment operations.  These types of disclosures may not enable investors to distinguish which, if any, derivatives are encompassed in the principal investment strategies of the fund or specific risk exposures they will entail. While more abbreviated disclosures could lead some investors to believe that a fund’s exposure to derivatives is minimal, the staff has observed that some funds using this type of disclosure appear to invest significantly in derivatives and may have substantial exposure to derivatives-related risks.  Conversely, the comprehensive nature of lengthy disclosures could lead some investors to believe that a fund has substantial exposure to derivative transactions, but the staff has observed that they actually appear to have relatively small exposure to derivatives.

The staff also has observed the practice of some fund complexes of providing the same derivatives-related disclosures for multiple funds even though the funds have significantly different exposures to derivatives. The disclosure is not always being tailored to each particular fund and therefore may not provide investors with meaningful information about the fund’s anticipated investment operations or how the fund’s portfolio will be managed, the staff said.

The staff believes that all funds that use derivative instruments should assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner using plain English.  In addition, any principal investment strategies disclosure related to derivatives should be tailored specifically to how a fund expects to be managed and should address those strategies that the fund expects to be the most important means of achieving its objectives and that it anticipates will have a significant effect in its performance.

The staff advised that in determining the appropriate disclosure, a fund should consider the degree of economic exposure the derivatives create in addition to the amount invested in the derivatives strategy. The disclosure also should describe the purpose that the derivatives are intended to serve in the portfolio and the extent to which derivatives are expected to be used.

The risk disclosure should also be tailored to the types of derivatives used by the fund, the extent of their use and the purpose for using derivatives transactions, according to the staff. The staff added that the risk disclosure should provide an investor with a complete risk profile of the fund’s investments taken as a whole, rather than a list of the risks of the various derivative strategies and should reflect anticipated derivatives usage.

The staff stated that a fund should assess the completeness and accuracy of the derivatives-related disclosures in its registration statement in light of its actual operations. In particular, a fund should assess whether it is meeting the disclosure requirements to completely and accurately disclose its anticipated principal investment strategies and risks. A fund should review its use of derivatives when it updates its registration statement annually and assess whether it needs to revise the disclosures in its registration statement that describes its principal derivatives strategies and risks, the staff said.

With respect to shareholder reports and financial statements, the staff has observed that some funds appear to have significant derivatives exposure in their financial statements, but their Management’s Discussion of Fund Performance (“MDFP”) includes limited or no discussion of the effect of those derivatives on the fund’s performance. Other funds include limited or no MDFP derivatives-related disclosure, but their registration statements disclose principal investment strategies that include the use of derivatives. The staff also has 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.

The staff advised that the MDFP is intended to provide shareholders with information about the factors that materially affected the fund’s performance during its most recently completed fiscal year and also should not be limited solely to forward-looking information. In addition, the MDFP should be consistent with operations reflected in the financial statements, and a fund whose performance was materially affected by derivatives should discuss that fact, whether or not derivatives are reflected in the portfolio schedule at the close of the fiscal year, the staff said.