A proposed federal rule would expand the ability of investment funds to boost their portfolios in other funds. But critics say it would require significant fund restructuring by the funds and burden investors. Under the Investment Company Act of 1940, the new Securities and Exchange Commission rule is intended to enhance the regulatory framework applicable to certain funds, including registered investment companies that invest in other funds—also known as fund of fund arrangements.
The proposed amendment allows an acquiring fund to invest all of its assets in a single fund so that in effect, it becomes a conduit through which investors may access the acquired fund. The rule also permits a registered fund to take small positions (up to 3% of another fund’s securities) in an unlimited number of other funds. In addition, it allows a registered open-end fund to invest in other open-end funds that are in the same “group of investment companies,” or two or more registered funds that hold themselves out to investors as related companies for the purpose of investment and investor services.
Expanding the limits
Under specified circumstances, the proposed rule would permit an investment fund to acquire more shares of another fund than the current limits allow without obtaining an exemption order from the SEC.
Currently, a registered fund is prohibited from:
- acquiring more than 3% of another fund’s outstanding voting securities
- investing more than 5% of its total assets in any one fund
- investing more than 10% of its total assets in funds generally
This restriction was made because Congress was concerned about “pyramiding,” a practice under which investors in the acquiring fund could control the assets of the acquired fund and use those assets to enrich themselves at the expense of the acquired fund’s shareholders. It was also believed that this technique would result in excessive fees when one fund invests in another, and results in overly complex structures that could be confusing to investors.
Popularity of fund of fund arrangements grows
Funds increasingly invest in other funds as a way to achieve asset allocation, diversification or other investment objectives. For example, a fund may invest in another fund to gain exposure to a particular market or asset class in an efficient manner. According to the Investment Company Institute’s 2018 Investment Company Fact Book, total net assets in mutual funds that invest primarily in other mutual funds have grown to $2.22 trillion in 2017 from $469 billion in 2008, and the number of funds utilizing this arrangement grew to 1,400 from 839.
According to SEC staff estimates, almost one-half of all registered funds hold investments in other funds. Of that cohort, one half invests at least 5% of their assets in other funds, and one quarter holds almost all of their assets in other funds.
Similarly, investors use fund of funds arrangements as a way to allocate and diversify their investments through a single, professionally managed portfolio, and do so without the increased monitoring and record-keeping that could accompany investments in each underlying fund. Similarly, fund of funds may provide an investor with exposure to an asset class or fund that may not otherwise be available to that investor.
Seeking benefits as well as protections
Over time, the views of Congress regarding fund of fund arrangements have evolved. Congress created statutory exceptions that permit different types of fund of funds subject to certain conditions. These amendments are believed to serve purposes that simultaneously benefit investors and protect them as required in asset management.
Comment letters argue that the effects on funds and investors outweigh the benefits in many respects. For instance, the proposal, if enacted, would require significant restructuring of current fund of funds arrangements, resulting in unnecessary costs and burdens to funds and their investors. Many affiliated fund of funds invest in affiliated and unaffiliated funds, and would be required to change their investment strategies, creating further headaches for asset managers.
Comments were received through May 2, 2019; a response from the SEC is pending.