WASHINGTON -- The Investment Company Institute is preparing a comprehensive memorandum on derivatives for mutual fund officials that will include recommendations on how derivatives risks should be managed and disclosed.
"It's really intended to be broad and all encompassing in terms of what fund directors and senior executives should be looking at when they invest in derivatives," said Greg Smith, director of operations for the institute, which represents some 200 to 300 mutual funds and fund groups.
The memorandum, which is expected to be sent to fund officials in the next few weeks, would come on the heels of a warning from SEC Commission Chairman Arthur Levitt that mutual funds must exercise "great care" in using derivatives.
It also comes in the wake of a congressional request for the Securities and Exchange Commission to undertake a comprehensive study of mutual funds' use of derivatives.
Reps. Edward Markey, D-Mass. and Jack Fields, R-Tex., the top lawmakers on the House Energy and Commerce Committee's subcommittee on telecommunications and finance, made the request last week. They asked the SEC to report back to them by July 18.
Levitt urged mutual funds to be cautious in their use of derivatives in separate letters that were sent late last week to Investment Company Institute president Matthew Fink and to the chief executive officers of about 50 groups of funds that control roughly 80% of fund assets.
Markey praised the letters in a statement, calling them "extraordinary" and "a welcome step in helping to determine how best to respond to the use of certain volatile derivatives by some mutual funds... "
The SEC chairman told Fink that while derivatives "used wisely ... can help manage risk or generate additional income," they can "pose significant risks.
"The complex and sometimes highly volatile nature of these products demands that funds operate with great care," he said.
Levitt said he is "troubled" by recent reports that some government bond and money market funds have experienced large losses from derivatives and, as a result, significant declines in value.
"It is apparent that at some funds derivative risks may not have been well-managed, and that resulting losses may have been unexpected by fund management and fund shareholders," Levitt said in the letter to Fink.
Levitt told fund officials: Fund managers must implement policies to ensure that derivative use is fully consistent with the fund's investment objectives.
"Close attention should be given to pricing, trading strategies, accounting issues, and internal controls," he said.
Levitt said fund directors should "actively participate" in the development of derivative policies and procedures and "exercise meaningful oversight" of all such internal controls.
The SEC chairman qualified his remarks in the letter to Fink, saying that fund directors need not "micromanage the minutiae of individual derivatives transactions" if they "exercise knowledgeable and meaningful oversight."
Levitt told the fund officials that he is particularly concerned about money market funds, which are subject to very strict limits on their portfolio investments. He urged that "special efforts be undertaken by those funds to ensure an appropriate level of safety."
Levitt asked Fink what steps fund managers are taking to address derivatives risks. He also asked whether:
* funds are setting and following limits on derivatives investments;
* fund portfolios with derivatives are being stress-tested to see how they would perform under a broad range of economic conditions;
* managers have the expertise to handle derivatives risks; and
* funds are disclosing information about their derivatives activities that is "not only technically correct, but ... also truly informative."
Investment Company Institute officials Will be responsive and will cooperative fully," with Levitt, Smith said.