Yesterday the Commission proposed rules on funds’ use of derivatives to obtain leverage.[1] Appropriate use of derivatives can produce benefits for investors, like better risk-adjusted returns or more efficient exposure to certain asset classes. But that same leverage also presents serious risks, magnifying losses for investors in times of turbulence. And the Commission’s historically piecemeal approach to these issues is insufficient given the growth in funds’ use of derivatives over the past several decades.

The Commission is long overdue in establishing a systematic approach that more meaningfully limits fund risktaking, so we support this proposal. We’re also encouraged that the proposal includes investor protection measures when leveraged and inverse funds—products that are rarely appropriate for retail use—are sold to ordinary investors. But we urge commenters to help the Commission strengthen the proposal in three areas that are critical for protecting investors from the risky use of derivatives by funds.

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First, the proposal provides some basic protections for ordinary investors who are sold leveraged and inverse exchange-traded funds. Those products are sold on the promise that they deliver a multiple, for example three times, of the returns of a particular index. These complex financial products may serve a legitimate purpose for a subset of sophisticated traders, but in a volatile market an ordinary investor can lose money in these products even when the index increases in value.[2] The disconnect between an ordinary American family’s reasonable expectations and the reality of these products creates real risk that too many investors will find out, too late, how dangerous these products can be.

That’s especially true because the data show that too many investors buy and hold these products on the expectation that they are sound investments over the long term—when they’re usually not.[3] Yesterday, the Commission proposed to address this problem by requiring brokers to follow certain practices when selling these products.[4] We hope commenters will come forward with evidence about whether these steps are enough to protect ordinary investors from the risks presented by leveraged and inverse funds.

Second, the proposal requires fund boards to appoint a manager to oversee its use of derivatives.[5] The proposal would not, however, require the board to approve the fund’s derivatives risk management program, and we are unpersuaded that hiring the risk manager is enough board-level engagement on the risks presented by derivatives use.[6] We understand that fund boards have limited time and expertise, but insufficient board involvement in this area can prevent development of the director-level proficiency needed to provide meaningful oversight and ensure sound risk management for investors. Board approval has served investors well in a broad range of areas—from audit[7] to executive pay[8] to investment company risk management[9]—and can create a structural incentive for directors to engage more actively in oversight. We hope commenters will come forward to help the Commission better understand the board’s role when it comes to derivatives.

Third, the proposal largely limits use of derivatives through constraints on funds’ portfolio risk. Those constraints generally require that a fund’s portfolio risk, including all derivatives investments, not exceed 150% of that of an index. And, to ensure that the use of an index provides meaningful limitations on funds’ leverage, the proposal prohibits the use of bespoke indices for that purpose.[10] To measure these matters, the proposal relies heavily on value at risk (VaR), a widely-used industry metric designed to measure the level of financial risk in a fund over a specified period of time.[11] The reliability of VaR as a risk metric is the subject of significant debate,[12] and is in any case largely dependent on the specifics of the model used. We believe that the Commission should consider further measures to ensure that funds’ VaR models are reliable and not subject to opportunistic gaming. The proposal includes certain minimum standards for VaR calculation, and we hope commenters will help us and the Staff better understand how to make sure that funds’ VaR models reflect the actual risks posed by the use of derivatives.

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We are grateful to the dedicated Staff in the Divisions of Investment Management and Economic and Risk Analysis for their extensive work on this proposal.[13] The questions addressed in yesterday’s proposal are exceptionally challenging ones, and the Commission, the marketplace, and investors have benefited a great deal from the Staff’s deep expertise. We now look forward to public input—especially regarding how the Commission can improve this proposal to ensure the protection of ordinary investors.