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|  |  | Speech by SEC Staff:"If I Were a Director of a Fund Investing in Derivatives — Key Areas of Risk on Which I Would Focus"*by*Gene Gohlke*Associate Director, Office of Compliance Inspection and ExaminationsU.S. Securities and Exchange Commission*Mutual Fund Directors Forum Program"Funds' Use of Derivatives"New York, New YorkNovember 8, 2007
Good afternoon. I am very pleased to be here today. I would like to thank the Mutual Funds Directors Forum for inviting me to speak and provide an opportunity to discuss a topic — mutual funds investments in derivatives — that is very much in the news today and our minds as examiners.

Before I go further, I must give the standard SEC disclaimer:

**The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.**
INTRODUCTION
As you are working your way through the agenda of this program, which is focused on mutual funds use of derivatives, you are learning that the scope of what constitutes a derivative instrument is broad and that derivatives range from the rather mundane convertible bond to the very complex, structured product known as a collateralized debt obligation and, of course, many things in-between. Just as the range of derivative instruments is broad so are the risks assumed by investors in these instruments. There are market, liquidity, leverage, counterparty, valuation, legal and structure risk to name only a few.

As fund directors you are responsible generally for overseeing your fund's investments to make sure that the risks assumed by the fund are consistent with the risk disclosures the fund has made to its shareholders.1 In addition, you are specifically responsible for establishing fair value procedures the fund is to use in pricing its derivative (and other) positions for which there are no readily available market quotations.2 You are also responsible for approving codes of ethics of both the fund and its investment adviser to ensure that the ethical principals established are appropriate in light of the environment in which the fund and adviser operate.3 Finally, you are responsible for determining that all of the fund's compliance policies and procedures and those of its service providers are reasonably designed to prevent violations of the securities laws.4

In my time with you today, I want to talk about certain aspects of a fund's involvement with derivative instruments that fund directors should pay particular attention to. The way I want to approach this presentation is to assume that I was a director of a fund investing in derivatives and then identify those areas of risk that I as a fund director would most want to focus on. In the text below, I focus on 12 areas of risk that I think are most important. Within each of these areas, I start by stating a question I would ask and then include a few related thoughts and comments designed to highlight specific activities, risks and compliance tests that I think are important. (Note that while the discussion below is framed in the context of a fund investing in derivatives, these same questions appear to be relevant as regards risks in most funds). As an actual fund director, I would expect to obtain answers to these questions from various of the fund's service providers, its CCO and legal counsel and then based on those answers, determine if the fund's exposure to the risks associated with its investments in derivatives is appropriate in light of fund shareholder's expectations.
IMPORTANT AREAS OF RISK- Does the fund's adviser have the intellectual and financial resources to be a knowledgeable, nimble participant in the derivatives in which the fund invests?       - How do the group's resources and abilities compare to those of the counterparties the fund will encounter in the marketplace?
  - Can the fund's adviser access and analyze all relevant information to be able to fully understand the probable risks and returns associated with a position; in particular, I as a director would be interested in the following:             - The specific derivative instruments in which the fund will be investing, the way in which each instrument will be used in achieving the fund's investment objectives and the significant risks associated with each instrument;
    - The information needed to make informed investment decisions and the sources of such information;
    - The means by which sources of information will be compensated;
    - How and by whom will that information be used;
    - Contingency plans to obtain information if the primary sources become unavailable; 
  - Does the fund's adviser have the necessary human and technological resources to make informed investment decisions and implement those decisions on the best possible terms and conditions;
  - Does the fund's adviser have the depth of knowledge and experience regarding each investment strategy employing derivatives so as to be able to effectively oversee and supervise the primary decision-makers and form the basis for backup and continuity of investment decision-making. 
- Do we investigate before we leap into an investment?       - Does the group use a well thought out process, often called a due diligence or new products process or committee, through which every proposed investment in a different type of derivative instrument is subject to vetting by knowledgeable persons from all operational areas (not just those operated by the adviser);
  - Is the objective of this due diligence process to fully probe, analyze and evaluate all features associated with a proposed investment to identify the risks and operational requirements that would come with such an investment and determine if the fund's service providers that will be impacted have or would be able to create the necessary infrastructure to timely and appropriately process, account for, custody, control and report on the new instrument;
  - Can investments in new instruments only be made after all associated risks have been identified and a determination is made that the infrastructure used by the fund's service provides will effectively handle the attributes of these instruments;
  - Does this due diligence process bring together in a deliberative format all disciplines or operational areas that may be impacted by the investment such as:             - Research
    - Portfolio management
    - Risk management
    - Trading
    - Clearance and settlement
    - Code of ethics and non-public information management
    - Custody/safekeeping
    - Recordkeeping
    - Pricing and valuation
    - Tax
    - Legal/contractual
    - Disclosure and investor reporting
    - Performance calculations
    - Compliance 
- Is there an effective investment risk management function that has the capacity to regularly identify, measure, evaluate and manage the fund's ongoing risk exposure?       - Does the fund's adviser maintain an appropriately staffed function that is independent of portfolio management and which is responsible for continuously measuring the extent of the fund's risk exposure using various tools such as value at risk, stress and scenario testing;
  - Is the risk information used to effectively manage the fund's exposure to risk to make sure the extent of risks taken remain within boundaries established in the fund's disclosures to its shareholders. 
- Are the investment and operational risks associated with the fund's investments in derivatives fully and fairly disclosed to the fund's shareholders in its prospectus/statement of additional information and in periodic reports to fund shareholders?   As a director, I would want to understand the process that is used to ensure that the ongoing level of risk to which the fund is exposed from its investments in derivatives is being fully and fairly described and illustrated in various disclosure documents provided to fund shareholders and that the language used to describe such risks is likely to be understood by the average investor in the fund. 
- Are all of the fund's service providers effectively preventing the inappropriate use of non-public information that may be received in connection with its investment in derivatives?       - Are the adviser's and fund's (and to the extent necessary, other fund service providers) code of ethics and the related policies and procedures established to prevent inappropriate decision-making using non-public information sufficiently broad, proactive and effective to monitor and manage information flows associated with the fund's investment in derivatives;
  - Do codes of ethics fully address relevant compliance with the federal securities laws by supervised persons in light of the possible additional sources of information and the types of information that will be needed to be an informed participant in the derivatives markets in which the fund is engaged;
  - Does testing of access persons trading in their personal accounts reflect ways in which derivatives can be used to effect long and short positions in issuers to take advantage of advance knowledge of trading by the fund or announcements by issuers;
  - Do policies and procedures established and implemented as required by Section 204A of the Advisers Act to prevent the inappropriate use of non-public information reflect effectively both traditional and non-traditional sources of information that may come into the possession of access persons. 
- Is the process used to measure and monitor liquidity/illiquidity of the fund's portfolio effective to ensure that the liquidity available is consistent with ongoing liquidity needs as measured by fund shareholders' purchase and redemption activity?       - Have the fund's service providers established and implemented a working definition of liquidity so everyone responsible knows what is to be measured and is using the same benchmark;
  - Have policies been established regarding how frequently liquidity measures will be calculated and the situation evaluated;
  - Have liquidity trigger points been established, using metrics such as various percentages of the portfolio in illiquid positions in relation to net redemption activity, that would require a review of the situation and perhaps changes in the portfolio to increase the amount of liquid assets available? 
- Is the process for defining, measuring and monitoring embedded or economic leverage associated with any of the fund's positions in derivatives effective to ensure that the fund's aggregate exposure to leverage is consistent with risk disclosures made to fund shareholders and statutory limitations?       - Have the fund's service providers established working definitions of economic leverage for the various derivatives in which the fund invests;
  - Is the amount of leverage to which the fund is exposed and the related risks measured regularly and are these metrics evaluated for consistency with disclosures made to fund shareholders and are remedial actions taken as appropriate;
  - Is economic (as well as any balance sheet) leverage assumed by the fund in its derivative positions being managed appropriately through the use of asset earmarking/segregated accounts to ensure the fund's compliance with statutory limitations? 
- Are the values for the fund's positions used in calculating its NAV reasonable in light of current market conditions?       - Do the processes used to value the fund's derivative positions, including the use of the fair value procedures adopted by the Board, provide substantial assurance that the value used each day for each derivative position held by the fund will reflect an amount the fund could reasonably expect to realize on that position in a closing transaction with a knowledgeable counterparty at the time daily NAV's are being determined;
  - With the above stated goal of the fund's valuation process in mind, as a director I would want information about such specific factors as:             - Source(s) of daily pricing information for derivative positions needed to calculate NAVs;
    - Tests applied to prices obtained from pricing services, dealer quotes and outputs of models to ensure that such prices are appropriate
    - If pricing information is obtained from a pricing service and the values are anything other than a pass through of closing market prices, familiarity with their process for determining values given to the fund
    - If internal models are used to create prices, the factors and assumptions used by such models and the periodic testing done to evaluate the appropriateness of the model inputs as well as the algorithms used in the model
    - Secondary sources of pricing information 
  - Knowing that the Board is responsible for fair valuation procedures and that derivatives may require fair valuing, the Board will need to obtain detailed information about the factors affecting the value of each of the different types of derivatives the fund may hold and how those factors can be used to estimate fair values;
  - I would also want to make sure that there was a regular flow of information coming to appropriate decision-makers regarding how the fund's fair value procedures are being used in practice and how accurate the fair values used are in estimating market values. In regard to accuracy of fair values, I would expect that a number of appropriate tests would be used to gauge such accuracy. The following are among the tests that could be used:             - Comparing today's prices for each instrument to yesterday's price
    - Change in today's price for an instrument from yesterday's price compared to change from yesterday to today in a relevant index or for comparable instruments
    - Identifying instruments whose prices have not changed over a period of a week or so, especially in times of volatile markets
    - Comparing change in fund's NAV from one day to the next to changes in one or more benchmarks to which the fund compares its performance or that reflect activity in the market sectors in which the fund is active
    - Volatility in a fund's NAV from day to day and over longer periods in relation to volatility in observable market factors and in comparison to internal estimates and projections
    - Periodically closing out one or more positions that have been fair valued for an extended period, using transactions that are otherwise consistent with investment decisions made for the fund's portfolio, to test the price realized upon close out to carrying value of the position in days leading up to the closing transaction
    - Compare all prices realized in closing transactions with arms length counterparties with previous day's carrying values and analyze differences for any pattern of skewing that suggests systematic over our under valuation
    - Compare prices fund uses to prices for the same instruments used by a prime broker or a counterparty for a position
    - Analyze trade blotter to look for a pattern of transactions with one or more BDs that are sources of quotes used to price fund positions (sham transactions) that suggests an attempt by fund insiders to manage the valuations used by the fund 
  - In addition to forensic testing, a number of other compliance procedures are important to ensure prices used accurately reflect current market factors. In particular I would want information regarding the controls used to manage overrides of prices obtained from pricing services, broker quotes or output of fair value models and specific information regarding any pattern of overrides for specific derivatives held by the fund;
  - Finally, I would want to understand the process used by the relevant service provider to properly classify each derivative position held by the fund on a financial reporting date into one of the 3 valuation tiers established by FASB 157 and whether written explanations of changes in Tier 3 exposures are accurate and understandable to the average reader? 
- Are operating processes used by the entities providing back office services for the fund's derivative positions robust, produce timely results and have sufficient depth to handle unexpected events and spikes in activity?       - Have all back office service providers such as administrators, pricing agents, and custodians established and implemented effective policies and procedures that address every aspect of the services they provide to the fund;
  - Do these service providers use relevant tests to measure the level and quality of their services and are the results of these tests available to the fund's CCO for oversight and monitoring purposes;
  - Have these service providers established effective processes for anticipating the occurrence of disruptive events and established backup plans and alternatives for handling the impact of these disruptive events. 
- Are the compliance procedures of the fund and its service providers effectively managing all material compliance risks regarding the fund's investments in derivatives and include a menu of testing for compliance in critically important areas?   As a fund director and knowing that the Board is responsible for reviewing and approving the compliance policies and procedures of its service providers:    - I would want to make sure the board focuses specific attention on those policies and procedures that are used to control critical activities regarding the fund's investments in derivatives such as information flows, liquidity, leverage and valuation;
  - I would devote specific attention to the forensic tests used to make sure such policies and procedures have been implemented effectively and that appropriate follow-up and corrective actions are taken regarding shortfalls and compliance breaches identified in exception and other compliance-related reports. 
- What role does the fund's CCO have in monitoring the fund's exposure to derivatives and how can the CCO be used most effectively as the "eyes and ears" of the Board in regard to overseeing the risks associated with the fund's investments in derivatives and ensuring that such risks are consistent with disclosures to and expectations of the fund's shareholders?   As a fund director I would engage in a continuing dialogue with the fund's CCO regarding how the CCO, giving due regard for all of the other responsibilities that come with the position, can assist the Board in effectively monitoring the fund's investments in derivatives, including the risks it is taking, the returns being earned for assuming those risks and how these risks and returns can most effectively be communicated to fund shareholders. 
- What information regarding the fund's exposure to derivatives' risks and returns will the Board get on a regular basis and what information should it get on an exception basis to keep it informed regarding the fund's investment in derivatives?       - As a fund director, I do not want to micro-manage the fund's investments in derivatives. However, recognizing that such investments can create a significant risk exposure for fund shareholders I would want either to receive or, at least, have access to reports prepared for other persons that would give the Board the information it needs to effectively oversee the fund's investments in derivatives in a manner that is likely to be consistent with the expectations of fund shareholders.
  - Examples of information for a fund investing in derivatives I would want to have access to on a regular basis (weekly /monthly), perhaps in the form of "dashboard reports" delivered in paper format or available in an on-line space on the group's internal web site, include the following:             - Average daily gross and net assets
    - Average of daily assets in illiquid positions as a percentage of daily net assets
    - Average of daily assets earmarked or in segregated accounts for Section 18 purposes as a percentage of daily net assets
    - Average daily net sales/redemptions as a percentage of net assets
    - Number of days during period in which the change from the previous day's NAV per share exceeded the per share value at risk for that period
    - Total return for the period compared to total return for the period on a relevant market index
    - Average daily total amount of assets for which fair value was used in calculating NAV as a percentage of average daily gross assets 
  - In addition to a regular flow of information as described above, I would have standing instructions with the fund's CCO and its service providers that I will want to be informed regarding unusual or exceptional matters that may arise regarding the fund's investments in derivatives. Examples of such matters could include, failure of a counterparty to a position held by the fund to perform as required; significant operational or control breach at a service provider; pricing model unraveling requiring a change in fair value procedures; and a sudden, material change in a measure that is otherwise reported to the Board on a periodic basis. 
ENDING THOUGHTS
I appreciate that many of the questions I've thrown out here today raise complex and difficult issues; often, they'll require different answers in different situations. But as a director, I would want to recognize that the potential benefits of investing in derivatives may quickly dissolve into disaster. I would want to understand those risks, be assured that the fund's service providers understood those risks, and have seen that appropriate processes and systems were put in place to manage, monitor, and mitigate those risks. Only then would I feel comfortable in exposing the fund and its shareholders to derivatives.

Thank you.
Endnotes
1 Under the Investment Company Act ("ICA"), a fund's board is expected to oversee the fund's operations on behalf of investors. See, e.g., Section 1(b)(2) of the ICA (15 U.S.C. 80a-1(b)(2) (public and investor interest served when investment companies are organized, operated, managed and portfolio securities are selected with the interest of all classes of shareholders in mind). While many of the specific ideas discussed below are not tasks fund directors are required to perform, in my opinion, they would fall within the oversight function.

2 Section 2a(41) of 1940 Act and rule 2a(4)(a)(1) thereunder.

3 Rule 17j-1(c)(1)(ii) under the 1940 Act.

4 Rule 38a-1(a)(2) under the 1940 Act.

*http://www.sec.gov/news/speech/2007/spch110807gg.htm*Home | Previous PageModified: 11/13/2007 |
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