Alternative mutual funds (“liquid alts”) have experienced explosive growth in recent years as investors continue to seek higher returns in the current low yield environment, while maintaining some protection against downside risk. The Securities and Exchange Commission’s (“SEC”) examination staff has taken notice, and recently announced a coordinated review (or “sweep”) of various liquid alts managers and funds.
Several factors contribute to the SEC’s interest in liquid alts. First, assets under management in liquid alts have surged in recent years, approaching $200 billion as of year-end 2013. Second, liquid alts are a relatively new product for retail investors, so their potential risks may not be well understood. Third, many alternative fund managers who manage liquid alts have limited experience with the regulatory requirements of the Investment Company Act of 1940 (the “1940 Act”), which are applicable to mutual funds including liquid alts. Similarly, many investment advisors with experience in managing mutual funds under the 1940 Act have limited experience with the alternative assets managed in liquid alts.
The SEC is keen to shift from reactionary regulation (for which the agency was criticized after the 2008 crisis) to proactive oversight. Therefore, we believe the SEC will scrutinize liquid alts and their managers closely in the upcoming sweep, likely focusing on the following requirements that commonly challenge liquid alts managers: liquidity, leverage, investment allocation, governance, and sub-advisor oversight.
This Regulatory Brief (a) provides background on liquid alts, (b) describes the SEC’s concerns, (c) suggests areas of future exam focus, and (d) offers suggestions on what industry participants can do now to prepare.