WASHINGTON -- The Investment Company Institute has sent mutual funds guidelines on derivatives in the wake of increased scrutiny from Congress, federal regulators, and the press.

The guidelines are contained in a 27-page memorandum that defines derivatives, outlines their possible uses, and details current regulatory issues as well as the risk management and disclosure responsibilities of fund officials.

The memorandum was sent late last week to institute members, which consist of about 400 mutual fund management companies, or 95% of the mutual funds in the nation, an institute spokesman said.

The institute memorandum follows a request by Rep. Edward J. Markey, D-Mich., and Rep. Jack Fields, R-Tex., that the Securities and Exchange Commission conduct a comprehensive study of mutual fund derivatives activities.

In addition, the SEC has sent letters to mutual funds and money market funds urging them to be cautious about derivatives and warning that some derivative products may not be appropriate for them.

In its memorandum, the institute said that "there is nothing inherently troublesome about fund investments in derivatives" and that, in many cases, derivatives help a fund achieve its investment objectives.

The memo broadly defines derivatives to include structured notes and participation interests in mortgage pools, as well as swaps, forwards, futures, and options on securities.

Funds use derivatives to hedge risks or to change the levels or kinds of risks to which their portfolios are exposed, the memo said. They may also use derivatives as cheaper, more focused investment alternatives to traditional securities, it said.

While some lawmakers would outlaw the use of derivatives for speculation, the institute warned, "it is misleading ... to suggest that all derivative instruments can be classified as either 'hedging' or 'speculation.' No such simple or stark dichotomy is possible."

Derivatives present "unique issues" for money market mutual funds, the memo said. Money market funds are required by federal securities laws to maintain constant net asset values and to comply with restrictions that are designed to minimize both credit and market risk.

* "Securities that do not meet these standards, whether or not they could be characterized as 'derivatives,' are not appropriate investments for money market funds," the memo said.

The institute called on fund directors to make sure they understand their fund's strategy for using derivatives, the nature of the derivative products being used, and the associated risks.

Noting that derivatives may be highly complex and untested by market events, the institute said, "The unfamiliarity of derivatives, including their capacity to surprise professionals as well as investors by their performance, has probably done more to give them a reputation for risk than any other factor."

The memo urged fund directors to determine whether their fund's traditional pricing procedures are appropriate for derivatives, which are sometimes difficult to price because they are specially tailored for certain investors.

Fund investment advisers, the memo said, should determine whether a derivative product is fairly priced and what factors will affect its return under different market conditions.

The memo stressed that funds must disclose certain information about their derivatives investments in their registration statements, prospectuses, sales literature, and periodic reports to shareholders.

Registration statements should disclose all significant investment practices and risks, including those relating to derivatives, it said.

A fund's derivatives investments should be consistent with its stated investment objectives and policies as well as with the risk profile that appears in any sales literature, the memo said.

"Put another way, the fund's investments in derivatives should be consistent with the reasonable expectations of the fund's investors," the institute said in the memo.

Prospectuses should describe a fund's derivatives activities in a simple nontechnical manner that investors can understand, the institute said.

Sales literature should accurately reflect the risks involved in investing in the fund, including the risks associated with the fund's derivative investors, it said.

The New York attorney general, the institute noted, recently settled charges it had brought against a municipal bond fund whose sales literature stressed its conservative nature and failed to disclose any of the risks of its derivatives investments. About 40% of the fund's assets were invested in products such as inverse floating-rate municipal bonds, the institute said.

For periodic reports to shareholders, the memo said, funds should disclose how derivatives were used during the periods covered by reports.

Turning to current regulatory issues, the memo said that a fund's derivatives investments should be consistent with federal securities law requirements on liquidity and valuation.

A mutual fund may not invest more than 15% of its net assets in "illiquid assets," the memo said. In addition, it said, a fund must value its net assets on a daily basis.

Some regulatory requirements pose problems for derivatives, the memo said. For example, federal securities laws limit the amount of securities of any one issuer that may be held by funds classified as "diversified companies." But it is not always clear who the issuer is in some derivatives transactions, the memo said.

The major tax issue for tax-exempt funds, the memo said, is ensuring that derivatives transactions are structured so that they produce only tax-exempt income for them and their shareholders.

The institute memo warned funds that they can expect continued scrutiny of their derivatives activities.

"Investment companies should expect increasing scrutiny of fund investments in derivatives by Congress, federal and state regulators, the financial press and the investing public," the memo said.

"For these reasons, fund directors and senior management and investment advisers should continue to exercise particular diligence with respect to their oversight and compliance responsibilities in this area," it said.

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