In letters to the SEC this week, firms including BlackRock Inc., Vanguard Group Inc. and State Street Corp. argued that derivatives have a role to play in managing large asset portfolios.

“Any set of mechanical rules cannot take account of the diversity of derivatives and the multiplicity of ways they may be used by portfolio managers,” BlackRock managing directors Joanne Medero and Ira Shapiro said in a Nov. 4 letter to the SEC. “Used appropriately, derivatives can be effective tools in seeking to achieve returns and control risks in funds.”

SEC commissioners approved a first step toward rulemaking known as a “concept release” on Aug. 31, posing questions about funds’ leverage, diversification and valuation of holdings in derivatives. The agency is weighing whether it should intervene to ensure fund managers are properly gauging risk and could move to impose rules limiting leverage and concentration. The public comment period on the release closed this week.

The SEC, which oversees mutual funds under the Investment Company Act of 1940, stopped approving applications for new exchange-traded funds that make significant use of derivatives in March 2010, pending a review of the practice.

“A relatively small investment in a derivative instrument can expose a fund to a potentially substantial gain or loss––or outsized exposure to an individual counterparty,” SEC Chairman Mary Schapiro said on Aug. 31.

$11 Trillion

The U.S. mutual-fund industry held $11 trillion in net assets in September, with another $952 billion in exchange- traded funds, according to the Investment Company Institute, a Washington-based trade association.

The SEC’s regulation of mutual funds’ use of derivatives is based on a 1979 agency release that didn’t specifically mention derivatives. That release was followed by a regulatory framework based on no-action letters and staff interpretations instead of new rules.

In its letter, Vanguard––which runs more than 170 mutual funds with about $1.5 trillion in assets––asked the SEC to resume considering applications for ETFs that seek to use derivatives. The letter, signed by Gus Sauter, Vanguard’s chief investment officer, and John Hollyer, the head of risk management, said new swaps rules under the Dodd-Frank Act “are likely to significantly reduce risk in swaps markets and should mitigate SEC concerns around fund swap investments.”

Vanguard and other companies asked the SEC to consider a flexible, principles-based system to regulating the instruments’ use in funds.

Risk-Based Approach

BlackRock, which manages more than $900 billion in hundreds of mutual funds and ETFs, said a “risk-based approach” is appropriate for deciding how much liquidity should be set aside against derivatives’ liability.

ETFs that don’t track an index should not “be prohibited from using derivatives in ways that are appropriate for their underlying strategies, disclosed to investors and commonly used by open-ended mutual funds,” the letter said.
Specialist managers of mutual funds, such as AQR Capital Management LLC, said they worry that tight restrictions could push them out of the arena completely.

Brendan R. Kalb, AQR’s general counsel, said in a letter to the SEC that “imposing regulations in a way that makes funds like ours impossible to offer, shrinks investment options to the detriment of mutual fund shareholders.”

Greenwich, Connecticut-based AQR, which has $38.5 billion under management, launched the first of its nine mutual funds in 2009, relying on derivatives to mimic strategies practiced by the hedge fund firm.

ETFs

Many of the companies responding to the concept release expressed particular concern about ETF rules.
“Provided ETFs offer sufficient transparency, their investment in derivatives should not raise any additional concerns,” said Phillip S. Gillespie, executive vice president and general counsel of Boston-based State Street’s investment-management arm, which advises funds with more than $175 billion in ETF assets.

Securities exchange operator NYSE Euronext said in an SEC letter, signed by Senior Vice President Janet McGinness, that “given the uniform regulatory framework, we believe that the inclusion of derivatives in ETFs do not raise unique investor protection concerns.”

John Nester, an SEC spokesman, said agency staff is analyzing the comments. He declined to speculate on when the regulator may push new rules.