Proposed SEC Rules May Provide A Window into the Black Box

By Bryan Rafie, Fall 2015 Student Intern

You have worked hard for 20 years and managed to stash away $50,000. Your savings account is earning .0001%. You have heard that you are actually losing money because of inflation. You talk to your father-in-law about it, and he introduces you to his “Guy.” Guy invites you to his office to talk about investing some of your savings.

Guy tells you he has been around the block a few times. He wants to make you money. You tell him that you’d like to see your savings grow, but really don’t want to take many risks. He points at charts and graphs, laughs boisterously, and walks you through his investment strategy in a unit investment trust. He seems to know what he is talking about. He does have a series of 7 different licenses, and is certified as a financial planner.

Before you hand him a check, he hands you a few disclosures about your investment. There are several boxes that detail the risks your taking and the costs etc. You look over them carefully. Everything Guy told you is listed. You hand him the check.

Now every quarter you get a statement that tells you how everything is going. The statement also updates you on the changes to the investment strategy of the plan and your account.   One day you open the statement and notice that your $50,000 is now $10,000. You yell, and scream, and cry. You pour over your statements and the SEC website, and come to find out that even though the fund was considered to be a medium risk, Guy and his firm had a separate account that borrowed against your investment to score extra gains and the derivatives you were invested were actually a lot more volatile than everyone thought.

The SEC oversees and regulates funds and investment advisers. They currently monitor roughly 16,500 different registered investment companies. These companies transmit financial reports to the SEC quarterly. The reports are compiled and evaluated for risk and compliance. The way derivatives, exchange-traded funds and unit-investment trusts are reported present a problem. Current regulation does not prescribe specific information the funds need to provide regarding investments in these areas. This lack of a standard disclosure requirement creates an inconsistency that makes the funds hard to evaluate and compare. So here is the proposed remedy to the problem:

The SEC has proposed changes to the reporting requirements. These proposed changes include:

  • Monthly reporting requirements for certain firms
  • Quantitative measurements of certain risk metrics
  • Detailed calculation of durations and spread of relevant maturities of a firm’s portfolio that allocates more than 20% of its portfolio to derivatives exposed to debt instruments or interest rates.

Although the proposed reporting regime may not directly help the average investor, it will help the SEC regulate funds that used to be considered black boxes. The updated information will enable them to delve deeper into the firm’s investment strategy and execution, allowing them to better understand the funds they oversee. If the SEC has a hard time understanding the inner workings of a fund they oversee, how can Guy, or any investment adviser for that matter, truly understand enough of the risks involved to make an intelligent recommendation?