Rule Change Could Crimp Alternative-Oriented '40 Act Funds
As managed futures get more attention from alternatives investors, a growing number of investment companies are rolling out mutual funds that replicate these strategies by using futures and commodities-related instruments. But a petition from the National Futures Association (NFA) to the Commodity Futures Trading Commission (CFTC) might change the way a fund that uses futures operates.

Traditional managed futures programs and '40 Act funds (regulated by the Investment Company Act of 1940) are different animals. The former are managed by commodity trading advisors (CTAs), who invest in a range of global futures markets and get paid for advising others about buying or selling futures contracts or commodity options. They're regulated by both the CFTC (with which they register) and the NFA, the self-regulatory organization of the futures industry. Many CTAs operate as, or are part of, commodity pool operators. These are often organized as limited partnerships and are also CFTC-regulated.

CTAs are an opaque niche where the top managers typically charge a 2% management fee, plus a 20% performance fee based on any new profits. And investment minimums are generally substantial.

Those fund structures bound by the 1940 act, meanwhile, help democratize managed futures strategies by making them available in SEC-registered funds that have much lower investment minimums, use less leverage, have greater transparency and entail easier tax reporting.

In 2003, an amendment to CFTC Regulation 4.5 governing commodity pool operators allowed registered investment companies-including mutual funds and exchange-traded funds-to engage in futures transactions without the previous requirements they be limited to legitimate hedging purposes and very minor amounts.

For fund companies to trade commodity futures, they have to create offshore entities called controlled foreign corporations-often based in the Cayman Islands-to hold their commodity futures-related income so they can still qualify for favorable U.S. tax treatment.
But the NFA is worried that certain entities are trying to take advantage of the exemption by creating mutual funds for retail investors that are being marketed as commodity futures investments and are, in essence, commodity pools. "If they're holding themselves out as a commodity pool, then they should be registered as a commodity pool operator," says NFA spokesman Larry Dyekman.

"There's concern more of these types of funds of CTAs will pop up [as mutual funds]," says Nadia Papagiannis, Morningstar's alternative investments strategist.

If the CFTC agrees to the NFA's petition to reinstate the earlier restrictions on futures trading in Rule 4.5, that could mean investment companies trading commodity futures or options could be regulated by both the CFTC and the SEC, says Michael Piracci, an attorney in the investment management practice at Morgan, Lewis & Bockius.

For now, fund companies such as Rydex|SGI, which offers four funds with trading strategies that require a controlled foreign corporation, can only wait to see what the CFTC does. "We will make sure that all of our funds are in compliance with any new legislation that passes," says Ryan Harder, a portfolio manager at Rydex|SGI. He adds there are other available strategies not requiring a controlled foreign corporation.

Some observers think toughening up Rule 4.5 could put a chill on future '40 Act funds in the managed futures space. "Where this goes will determine if the mutual fund approach will be viable for folks who want a managed futures strategy in a vehicle with a different regulatory oversight structure, distribution approach and tax approach," says John Grady, chief operating officer and general counsel at Steben & Co., a Rockville, Md.-based company that provides individual and institutional investors with access to CTAs.

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