As with Fund-of-Funds, the release adopting Rule 18f-4 (the “Adopting Release”) devotes a section to sub-advised funds. We again consider three types of funds:

  • VaR Funds in which a sub-adviser manages their entire portfolio (“Single Sub-Adviser Funds”);
  • VaR Funds in which one or more sub-advisers manage a portion or “sleeve” of their portfolio (“Sleeve Funds”); and
  • Sub-advised funds that seek to qualify as Limited Derivatives Users.

The Adopting Release discusses the first two circumstances but is silent on the third.

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This post continues our assessment of whether the Limited Derivatives User requirements of Rule 18f-4(c)(4) effectively and efficiently accomplish the SEC’s aim of providing “an objective standard to identify funds that use derivatives in a limited manner.” Here we question whether the “gross notional amount” of a derivatives transaction measures the means and consequences, rather than the extent, of its use.

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The financial press is awash this morning with reports that the launch of a bitcoin futures exchange-traded fund (a “BTC Futures ETF“) may be imminent.

Before recommending that clients invest directly in bitcoin or in a BTC Futures ETF, a registered investment adviser (RIA) should analyze: Continue Reading RIAs and Bitcoin Futures ETFs: Forget Not Thy CPO and CTA Analysis

Our last series of posts on Rule 18f-4 have struggled to understand how its Limited Derivatives User requirements are supposed to work. We have done the best we could to explain the process for calculating a fund’s derivatives exposure, including determining the gross notional amount of derivatives transactions and adjustments thereto, excluding closed-out positions and currency and interest-rate derivatives entered into for hedging purposes, and applying the “10% buffer” for these hedges. In this series of posts, we shift our perspective to assessing whether these requirements effectively and efficiently accomplish the SEC’s objectives.

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As has been our practice in this series on new Rule 18f-4, we end our survey of its Limited Derivatives User requirements with a compliance checklist. This checklist reiterates much of our earlier post on Derivatives Exposure: Why It Matters And How To Calculate It, but provides more details and includes required policies and procedures and steps required if a fund exceeds the 10% limit on its derivatives exposure. Given the length of the checklist and the difficulty in controlling the format of printed copies of this blog, we are providing the compliance checklist through a link to a PDF.

This post will address another ambiguity in the “10% buffer” Rule 18f-4 provides for excluding the notional amount of derivative transactions that hedge currency or interest rate risks (“Hedging Derivatives”) when calculating the Derivatives Exposure of a Limited Derivatives User. The ambiguity is whether, once the notional amount of a Hedging Derivative exceeds the 10% buffer, a fund should add back to its Derivatives Exposure (a) the entire notional amount of the Hedging Derivative or (b) only the notional amount in excess of the 10% buffer. We chose answer (b) in our post on The 10% Buffer and Changes in Hedged Investments. This post explains why.

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This post continues our examination of the “10% buffer” for Hedging Derivatives, which refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value, par or principal amount of the hedged equity and fixed-income investments. In this post we consider whether funds should apply the 10% buffer to Hedging Derivatives in the aggregate or on a “hedge-by-hedge” basis.

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By Stephen A. Keen and Andrew P. Cross

This post continues our examination of the “10% buffer” for Hedging Derivatives, which refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value of hedged equity investments, par amount of hedged fixed-income investments or principal amount of hedged borrowings. In this post we examine what it means for Hedging Derivatives to exceed the 10% buffer.

Application of the 10% Buffer

The 10% buffer is intended to address:

situations, such as shareholder redemptions or fluctuations in the market value of a hedged investment, that can temporarily cause the notional amounts of the hedges to exceed the value of the hedged investments by more than a negligible amount.”

This should

avoid funds frequently trading (and incurring the attendant costs) to resize their hedges in response to small changes in value of the hedged investments.”

Consider, for example, a Limited Derivatives User holding euro denominated equity investments with a current value of €10 million that enters into 80 of the September 2022 Euro FX Futures to sell a total of €10 million for a total of $11,908,000. What would the consequences under Rule 18f-4 be if, a month later, the value of the equity investments has fallen to €9 million?

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We promised a few posts back to discuss how a Limited Derivatives User should apply what we termed the “10% buffer” to determine whether currency and interest-rate derivatives may be excluded from its derivatives exposure. This post begins to tackle the question What is the 10% Buffer? and explain how it might work.

What is the 10% Buffer?

Our earlier post described the conditions under which a fund seeking to comply with the Limited Derivatives User requirements of Rule 18f-4 could exclude currency and interest-rate hedges (“Hedging Derivatives”) from its derivatives exposure. The third condition is that the notional amount of Hedging Derivatives:

do not exceed the value of the hedged investments (or the par value thereof, in the case of fixed-income investments, or the principal amount, in the case of borrowing) by more than 10 percent.“

The “10% buffer” refers to the amount by which the notional amounts of Hedging Derivatives can exceed the value or par amount of the hedged investments or principal amount of hedged borrowings.

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By Stephen A. Keen and Andrew P. Cross

Our last post examined examples of currency hedges that we believe Rule 18f‑4(c)(4)(i)(B) should allow a fund seeking to comply with the Limited Derivatives User requirements to exclude from its derivatives exposure. This post struggles with examples of interest-rate hedges that may, or may not, be excluded.

A Paradigmatic Bond Hedge

As originally proposed, Rule 18f-4 would have excluded only currency hedges. The final rule added the exclusion of interest-rate hedges based on commenters who:

routinely enter into fixed-to-floating interest rate swaps (or vice versa) and [match] these transactions … to the notional amount and maturity of a specific security in the fund’s portfolio.”

As the SEC added the exclusion of interest-rate hedges to accommodate these commenters, it is reasonable to conclude that such a fixed-to-floating rate swap could be excluded from a fund’s derivatives exposure. We are less sure about the “vice versa,” as a floating-to-fixed rate swap would increase, rather than mitigate, a fund’s interest-rate risk. We do not believe the SEC would view using derivatives to increase duration as a “hedging purpose.”

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