The SEC is Nervous About Options

Why is the SEC nervous?

On February 23, 2018, Commissioner Kara M. Stein gave a speech at SEC Speaks in Washington, DC. During the speech, Commissioner Stein raised broad ethical and economic considerations regarding the rapid advances in financial product innovation, which appears to be accelerating as financial firms increasingly use technology to expand their product line and deepen their reach into retail markets.

The speech came just a few weeks after the LJM Perseveration and Growth Fund lost nearly $800 million in value (over 80% of its value). The most public blow-up of a mutual fund in years, the LJM Fund used options and other derivative products to bet on volatility. The fund, which launched in 2013, grew rapidly despite its high expense ratio. But after its rapid ascent was an even faster decline, as the fund closed to new investors and was sued by old investors. (You can read more about the LJM Fund in this Barron's article.) In addition to the LJM Fund implosion, other exchange-traded products took a fatal plunge during the market declines of early February.

All of these product failures left the SEC skittish about financial innovation and whether such innovation is good for retail investors. As a result, the regulator is putting the breaks on attempts to register new products that use similar strategies and structures based on derivatives, including futures, options, and custom indices.

Launching an Options Fund: dos and don'ts

Asset managers looking to manage complex strategies in a mutual fund should proceed with caution. With increased SEC scrutiny comes increased board scrutiny, and many fund boards may be uncomfortable concluding that such strategies are appropriate for retails investors. Therefore, asset managers should ensure that their strategy pitch and the disclosure of both strategy and risk, is clearly and concisely presented in 15(c) materials registration statements. Further, boards and managers should consider setting higher minimum investment thresholds to signal to the SEC that these products are not designed for the everyday retail investor. Great disclosure and high minimums may be enough to get the SEC to allow derivative heavy funds to go to market. If not, then managers may need to be patient, as the markets and the SEC go through a cooling off period.

1933 Act Investment Advisers LJM Fund Options SEC Updates 1940 Act Derivatives Directors/Trustees

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