June 20--Government regulators think you might be getting led astray by mutual funds and ETFs that could act like wolves in sheep's clothing.
Securities and Exchange Commission Commissioner Kara Stein said in a recent speech to the Brookings Institute that regulators have fallen behind in keeping tabs on some potentially dangerous investments. And individuals could be shocked by the risks they have unwittingly taken.
Typically, people are comfortable with mutual funds and exchange traded funds (ETFs), because they know they can yank money quickly from the funds if they get worried about losses or need spending money. But Stein said the assumption could be wrong in conjunction with some of the newly designed complex funds that have been pouring onto the market since 2009. In fearsome periods, nervous investors could all rush to get hold of their money fast, and find it impossible.
Under rules that pertain to mutual funds, a person is supposed to get their money back within seven days of asking, or selling shares. But Stein notes that some complex investments aren't designed for the quick retrieval people get from stocks and bonds.
Stein is concerned about relatively new funds, known as "alternatives," or funds with strategies that until recently weren't used in funds geared toward average Americans. The strategies used to be reserved for hedge funds and institutions that could afford a loss easier than the average person. In particular, Stein flagged concerns about "floating rate bond funds" or "bank loan funds" that have become popular the last few years among relatively cautious investors.
With the bank loan funds, individuals might assume they have a relatively safe bond fund. But Stein said: "Do retail investors truly understand?"
She emphasized that protecting investors is especially important now because there will be 88 million retirees by 2050 who must invest effectively so they don't run out of money in an era without guaranteed pensions.
Alternative funds, or so-called liquid alternative funds, have soared in popularity since 2009. Morningstar estimates about $313.3 billion is invested in them, up from $72.5 billion in 2009. There is about $18 trillion in all mutual funds and exchange traded funds.
The fund industry has pumped out "alternatives" to stocks and bonds because the new strategies typically charge individuals higher fees. And after the financial crisis, individuals also wanted to earn more income than they could in bonds and CDs amid ultra-low interest rates. They were also gun-shy of stocks after 50 percent losses in the financial crisis.
Stein is concerned about some alternative funds taking on huge debts with potentially explosive strategies. They borrow significantly to make their investments, and borrowed money can become a dangerous trap if an investment goes bad. It would accentuate losses for people with money in the funds.
Stein noted that "derivative usage has skyrocketed since 1979." Yet the SEC hasn't alerted unsuspecting individuals, she said. Derivatives come in many forms, but it was a mixture of borrowed money and derivatives related to housing that were involved in some of the intense losses in the financial crisis of 2008.
Ironically, the craze for alternatives was an outgrowth of that time period. As the Federal Reserve tried to bring life back into the economy, it cut interest rates to near zero. That resulted in individuals earning very little interest in bonds and seeking an alternative. Meanwhile, after suffering 50 percent losses in the stock market, stocks lost some appeal.
Bank loan funds became particularly attractive after 2009, because analysts continually predicted that the Federal Reserve would raise interest rates. And rising rates would cause people to lose money in traditional bond funds. The surge in rates is yet to come. But when they do, bank loan funds supposedly will be somewhat insulated from losses. Banks make floating rate loans to companies that are financially troubled, and the yields adjust up frequently when interest rates are rising. Still, in a recession, loans to troubled companies may not do well.
Stein thinks the bank loan funds are more risky than people realize because a person might try to get money out of a fund and have difficulty. Stocks and bonds can be sold instantly. Bank loans can't be as easily turned into cash if a lot of investors want to take their money and run.
gmarksjarvis@tribpub.com
