UNITED STATES
 

SECURITIES AND EXCHANGE COMMISSION
 

WASHINGTON, D.C.20549
 

DIVISION OF 

INVESTMENT MANAGEMENT July 30,2010 

Karrie McMillan, Esq. 

General Counsel 

Investment Company Institute 

1401 H Street, NW 

Suite 1200 

Washington, DC 20005 

Re: Derivatives-Related Disclosures by Investment Companies 

Dear Ms. McMillan: 

As you are aware, the staff ofthe Securities and Exchange Commission is 

conducting a review to evaluate the use of derivatives by mutual funds, exchange-traded 

funds, and other investment companies. 1 This review is ongoing, and includes, among 

other things, exploring whether existing prospectus disclosures adequately address the 

particular risks created by derivatives. At this time, we are writing to provide some 

observations we have made about current derivatives-related disclosures by investment 

companies in registration statements and shareholder reports. We are providing these 

observations now, prior to completion of our review, because we believe these 

observations may give investment companies immediate guidance to provide investors 

with more understandable disclosures related to derivatives, including the risks associated 

with them.2 We request that you communicate our observations to all of your members. 

Registration Statement Disclosures 

Form N-1 A, the form used by mutual funds to register under the Investment 

Company Act of 1940 and to offer their securities under the Securities Act of 1933, 

requires a fund to disclose its principal investment strategies, including the type or types 

of securities in which the fund principally invests or will invest. 3 Further, Form N-IA 

See "SEC StaffEvaluating the Use ofDerivatives by Funds," SEC Press Release 2010-45 (Mar. 

25,2010), available at: http://www.sec.gov/news/press/201O/201O-45.htm. 

While we primarily refer to registered open-end management investment companies, or mutual 

funds, in this letter, our observations also generally relate to other types of registered investment companies 

and business development companies. 

See Items 4(a) and 9(b) of Form N-1A. Whether a particular strategy, including a strategy to 

invest in a particular type of security, is a principal investment strategy depends on the strategy's 

anticipated importance in achieving the fund's investment objectives, and how the strategy affects the 

fund's potential risks and returns. See Instr. 2 to Item 9(b) of Form N-1A. In assessing what is a principal 

investment strategy, a fund should consider, among other things, the amount of the fund's assets expected 

to be committed to the strategy, the amount of the fund's assets expected to be placed at risk by the 

strategy, and the likelihood of the fund losing some or all of those assets from implementing the strategy. 

Id. 
requires a mutual fund to disclose the principal risks ofinvesting in the fund, including 

the risks to which the fund's particular portfolio as a whole is expected to be subject and 

the circumstances reasonably likely to affect adversely the fund's net asset value, yield, 

or total retum.4 Investment strategies used by a fund that are not principal strategies and 

the risks ofthose strategies should generally be disclosed in the fund's Statement of 

Additional Information. 5 

When this disclosure framework was adopted in 1998, the Commission noted that 

it intended the prospectus disclosure to focus on a fund's principal investment strategies 

in order to provide investors with more useful information about the fund's investment 

approach and how the fund's portfolio will be managed. 6 The Commission stated that a 

fund should disclose in its prospectus those strategies that it expects to be the most 

important means of achieving the fund's objectives and that the fund anticipates will have 

a significant effect on its performance.7 The Commission also stated that it intended to 

focus the prospectus disclosure on how a fund achieves or intends to achieve its 

investment objectives, and to move the disclosure away from the practice oflisting all 

types of securities in which it may invest.8 That is, the approach was designed to focus 

disclosure on a fund's anticipated investment operations, rather than on investments that 

the fund might make. 9 

We have observed derivatives-related disclosures by some funds that we believe 

may not be consistent with the intent of Form N-1A's requirements described above and 

which could be improved. Our primary observation is that some funds provide generic 

disclosures about derivatives that, in our view, may be oflimited usefulness for investors 

in evaluating the anticipated investment operations of the fund, including how the fund's 

investment adviser actually intends to manage the fund's portfolio and the consequent 

risks. 10 

The generic disclosures vary from highly abbreviated disclosures that briefly 

identify a variety of derivative products or strategies, to lengthy, often highly technical, 

disclosures that detail a wide variety of potential derivative transactions without 

explaining the relevance to the fund's investment operations. Regardless of the style and 

format, funds with generic derivatives-related disclosures: (1) typically state as a 

principal investment strategy that they will or may engage in derivative transactions, and 

4 See Items 4(b) and 9(c) ofForm N-1A. 

See Item 16(b) ofForm N-1A. 

See Investment Company Act Release No. 23064 (Mar. 13, 1998) [63 FR 13916, 13926 (Mar. 23, 

1998)]. 

Id. 

Id. ("[D]isclosing information about all of the securities in which a fund might invest does not 

help a typical fund investor evaluate how the fund's portfolio will be managed or the overall risks of 

investing in the fund."). 

Id. 

10 Id. See also Items 4(a) and 9(b) ofForm N-1A (requiring a fund to disclose how it "intends to 

achieve its investment objectives"). 

2 
then often enumerate all or virtually all types of derivatives as potential investments; 

(2) may provide generic language about the purpose for using derivatives (~,

derivatives may be used for "hedging or non-hedging purposes"); and (3) may 

characterize broadly the extent of the transactions ~, the fund may invest "all" of its 

assets in derivatives).ll Whereas funds with abbreviated disclosures typically list the 

types of derivatives, with little or no explanation ofthe nature ofthe instruments, those 

with lengthy, often highly technical, disclosures typically provide an extensive and 

complex explanation of the various derivatives that might be used and is not always 

provided in plain English. 

Funds that provide abbreviated disclosures typically also provide generic risk 

disclosure, which, while appropriately citing various potential risks (~, correlation, 

counterparty, credit, leverage, liquidity, market, and valuation risks), again provide 

limited explanation of those risks and may not be tailored to the specific derivative 

instruments in which a fund invests or will invest principally. Funds that provide 

lengthy, often highly technical, disclosures generally provide risk disclosure that is more 

tailored to each specific type of derivative, but the complex and lengthy disclosure 

reduces its usefulness for investors. 

The types of generic disclosures discussed above may not enable investors to 

distinguish which, if any, derivatives are in fact encompassed in the principal investment 

strategies of the fund or specific risk exposures they will entail. Indeed, while more 

abbreviated disclosures could lead some investors to believe that a fund's exposure to 

derivatives is minimal, we have observed that some funds employing this type of 

disclosure, in fact, appear to invest significantly in derivatives and thereby may have 

substantial exposure to derivatives-related risks. Conversely, the comprehensive nature 

oflengthy, often highly technical, derivatives-related disclosures could lead some 

investors to believe that a fund with such disclosure would have substantial exposure to 

derivative transactions, yet we have observed that some funds providing this disclosure 

actually appear to have relatively small exposure to derivatives. 12 

Reliance upon generic, even standardized, derivatives-related disclosures is 

further evidenced by the practice of some fund complexes that provide the same 

derivatives-related disclosures for multiple funds, even though the various funds have 

Ii Our observation about the practice by some funds of listing under principal investment strategies 

all possible fund investments is not limited to derivatives. When the staff of the Division ofInvestment 

Management observes such disclosure, it will continue to provide comments, as appropriate, that consistent 

with the intent of Form N-1A's requirements, a fund should not list all types of possible investments, but 

rather focus on the principal strategies and investments that the fund intends to use to achieve its 

investment objectives. 

We have also observed funds with derivatives-related disclosures in their registration statements 

that do not appear to communicate the significant derivatives exposure reflected in the financial statements 

or the Management's Discussion ofFund Performance ("MDFP"), contained in the annual reports to 

shareholders. Below, we include observations about derivatives-related disclosures included in fund 

shareholder reports and financial statements. See infra "Shareholder Reports and Financial Statements 

Disclosures"; see also infra footnotes 18 and 19 and accompanying text (describing MDFP disclosure 

requirements). 

3 

12 
significantly different exposures to derivatives. 13 Such a practice again demonstrates that 

the disclosure is not always being tailored to each particular fund and thus may not 

provide investors with meaningful information about the fund's anticipated investment 

operations or how the fund's portfolio will be managed. 

Given these observations, we believe that all funds that use or intend to use 

derivative instruments should assess the accuracy and completeness oftheir disclosure, 

including whether the disclosure is presented in an understandable manner using plain 

English. Further, any principal investment strategies disclosure related to derivatives 

should be tailored specifically to how a fund expects to be managed and should address 

those strategies that the fund expects to be the most important means of achieving its 

objectives and that it anticipates will have a significant effect on its performance. 14 In 

determining the appropriate disclosure, a fund should consider the degree of economic 

exposure the derivatives create, in addition to the amount invested in the derivatives 

strategy.15 This disclosure also should describe the purpose that the derivatives are 

intended to serve in the portfolio (~, hedging, speculation, or as a substitute for 

investing in conventional securities),16 and the extent to which derivatives are expected to 

be used. 

Additionally, the disclosure concerning the principal risks ofthe fund should 

similarly be tailored to the types of derivatives used by the fund, the extent oftheir use, 

and the purpose for using derivative transactions. 17 The risk disclosure in the prospectus 

for each fund should provide an investor with a complete risk profile ofthe fund's 

13 For example, some funds may use all types ofderivatives, others use some types, and still others 

use derivatives sparingly. Investors are left with no way to distinguish the risk exposure of a particular 

fund. While the fund's financial statements and the MDFP in its annual report may help explain the risk 

exposure, the prospectus itself should include adequate disclosure for an investor to determine the principal 

investment strategies and risks of the fund. 

14 In the staffs view, referencing all types of derivatives, if such derivatives are not expected to be 

used in connection with the fund's principal strategies, is not consistent with the intent of Form N-IA's 

requirements. Any strategy that is not a principal investment strategy, including one involving derivatives, 

should be clearly described as non-principal in the registration statement. See Item 16(b) of Form N-IA. 

15 See Instr. 2 to Item 9(b) of Form N-IA. Derivatives-related disclosure should also be provided 

commensurate with the level of derivatives exposure of a fund. For example, a small investment in some 

derivatives does not necessarily correlate with little effect on a fund's performance because of the impact of 

leverage. Alternatively, a fund may have significant exposure to derivatives, but that exposure may not 

make the fund substantially riskier (~, exposure by an international fund to currency forwards, entered 

into to hedge against the currency risk of securities that trade in those currencies would more likely reduce 

the fund's overall risk, rather than increase it). 

16 For example, some funds invest in the combination of an equity-linked derivative and fixedincome securities to create the economic equivalent ofinvesting directly in the underlying equity security. 

Some funds invest in derivatives in an attempt to enhance returns, i.e., to magnify the gain. Still other 

funds may invest in interest rate swaps to hedge against their interest rate exposure. 

17 As noted, some funds generically describe the risks of investing in derivatives, yet different 

derivatives are subject to varying risks. For example, derivatives that are not traded on an exchange may 

be subject to heightened liquidity and valuation risks. 

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investments taken as a whole, rather than a list of the risks of various derivative 

strategies, and should reflect anticipated derivatives usage. 

Finally, a fund should assess the completeness and accuracy ofthe derivativesrelated disclosures in its registration statement in light of its actual operations. In 

particular, a fund should assess, based upon its actual operations, whether it is meeting 

the disclosure requirements to completely and accurately disclose its anticipated principal 

investment strategies and risks. A fund should review its use of derivatives when it 

updates its registration statement annually - particularly disclosures in its shareholder 

reports - and assess whether it needs to revise the disclosures in its registration statement 

that describes its principal derivatives strategies and risks. 

Shareholder Reports and Financial Statements Disclosures 

We also have observations regarding mutual fund disclosures contained in 

shareholder reports and financial statements. Mutual funds (except for money market 

funds) must provide Management's Discussion of Fund Performance ("MDFP") in their 

annual report to shareholders. I8 Among other things, the MDFP must discuss the factors 

that materially affected the fund's performance during its most recently completed fiscal 

year, including the relevant market conditions and the investment strategies and 

techniques used by the fund's investment adviser. 19 

We have observed some funds that appear to have significant derivatives 

exposure in their financial statements, yet their MDFP includes limited or, in some cases, 

no discussion ofthe effect ofthose derivatives on the funds' performance. Other funds 

also include limited or, in some cases, no MDFP derivatives-related disclosure, yet their 

registration statements disclose principal investment strategies that include the use of 

derivatives. Additionally, we have observed some funds with MDFP derivatives-related 

disclosure that is solely forward looking and does not discuss the impact of derivatives on 

performance for the most recently completed fiscal year. 

Given these observations, we remind funds that the MDFP is intended to provide 

shareholders with information about the factors that materially affected the fund's 

performance during its most recently completed fiscal year and also should not be limited 

solely to forward-looking information?O Further, the MDFP should be consistent with 

operations reflected in the financial statements, and a fund whose performance was 

materially affected by derivatives should discuss that fact, whether or not derivatives are 

reflected in the portfolio schedule at the close of the fiscal year. 

18 See Item 27(b)(7) ofFonn N-1A. 

19 Id. 

20 See Investment Company Act Release No. 19382 (Apr. 6, 1993) [58 FR 19050, 19053 (Apr. 12, 

1993)] ("[T]he item [requiring MDFP disclosure] requires funds to explain what happened during the 

previous fiscal year and why it happened. The narrative must describe what techniques or strategies, within 

the fund's investment objectives and limitations, management used that, together with market conditions 

and events, resulted in the performance of the fund."). 

5 
Additionally, we have observations related to derivatives-related disclosures 

contained in the annual and semi-annual financial statements offunds required by U.S. 

GAAP and Regulation S-x. We note that some funds can improve certain disclosures 

prescribed by FASB Accounting Standards Codification Topic 815: Derivatives and 

Hedging ("Topic 815"), which requires, among other things, funds to provide qualitative 

disclosures about their objectives and strategies for using derivative instruments.21 

Additionally, for sellers of credit derivative instruments, Topic 815 requires entities to 

disclose the payment/performance risk associated with the instruments.22 

In our reviews of fund financial statements, we have found that some funds could 

improve their disclosures when meeting Topic 815's requirement to provide qualitative 

disclosures about their objectives and strategies for using derivative instruments by 

addressing the effect of using derivatives during the reporting period. While many funds 

state that they "may" engage in certain types of derivatives transactions, they do not 

provide qualitative information about how the funds achieved their objectives and 

strategies by using derivative instruments during the reporting period. The financial 

statements and accompanying notes should inform shareholders how a fund actually used 

derivatives during the period to meet its objectives and strategies. 

Topic 815 also requires sellers of credit derivatives to disclose, among other 

things, the nature of the credit derivative, including, but not limited to, the current status 

of payment/performance risk ofthe credit derivative?3 Funds that sell protection 

through credit default swaps often include credit spreads as part oftheir disclosures. We 

note that some ofthese funds could improve their disclosures by explaining the relevance 

ofthose spreads. For example, these funds could explain the significance ofthe size of 

the credit spreads in relation to the likelihood of a credit event or the possible 

requirement for funds to make payments to counterparties. 

Also in our reviews offund financial statements, we have noted that, while most 

funds disclose counterparties to forward currency and swap contracts reported in the 

schedule of investments, some funds do not.24 In addition to the risks associated with a 

particular derivative instrument (~, credit, currency, or interest rate risks), over-thecounter derivatives are subject to the risk of nonperformance by the counterparty. 

Accordingly, in the staffs view, the identification ofthe counterparty is a material 

component of the description and should be disclosed. 

* * * 

We will continue to review fund registration statements and shareholder reports to 

evaluate fund disclosures related to derivatives. Among other things, we will continue to 

review fund registration statements to assess whether a fund's principal investment 

21 See FASB ASC 815-10-50-1A. 

22 See FASB ASC 815-10-50-4K. 

23 Id. 

24 See generally Rule 12-13 of Regulation S-X, at footnote 1 [17 CFR 210.12-13]. 

6 
strategies and risks are presented in plain English, and discuss the relevance of derivative 

transactions to the fund's investment operations. Where appropriate, we will query 

whether the strategies listed are, in fact, principal investment strategies and whether the 

risk disclosure is tailored to those strategies. We also will continue to compare a fund's 

investment objectives, strategies and risks in its registration statement to its shareholder 

reports to assess whether the disclosures regarding the fund's operations appear to be 

consistent with its registration statement disclosures. Similarly, we will continue to 

review financial statement disclosures, including assessing whether derivatives-related 

disclosures in financial statements appears to be consistent with the MDFP. Accordingly, 

we encourage all funds that use derivative transactions to review their disclosures related 

to derivatives to assess whether they are meeting their disclosure obligations and whether 

their disclosures could be improved. 

We hope that this letter will help your members provide investors with more 

understandable disclosures related to derivatives. If you have any questions regarding 

our observations related to registration statement disclosures, please contact Frank J. 

Donaty at 202-551-6925 or Brent J. Fields at 202-551-6921, Assistant Directors in the 

Office of Disclosure and Review, or related to shareholder reports and financial 

statements disclosures, please contact Richard F. Sennett at 202-551-6918, Chief 

Accountant in the Office ofthe Chief Accountant, Division ofInvestment Management. 

Sincerely, 

Barry D. Miller 

Associate Director 

Office ofLegal and Disclosure 

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