Warren Buffet on Derivatives
“In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” ~ Excerpt from the 2002 Berkshire Hathaway Annual Report
Buffet’s comments were particularly prescient six years later when credit derivatives played a major role in the 2008 credit crisis. Some of the risks still exist today and are being addressed by regulators, however, it is important to understand not all derivatives are weapons of mass destruction and the context of the derivatives in a portfolio can have a dramatic impact on the risk to investors. We will examine the proposal and draw implications for advisers to separately managed accounts.
At its open meeting on December 11, 2015, the SEC voted to propose new rules for registered funds that invest in derivatives. The SEC is planning to propose an ‘exemptive rule’ that would restrict the use of derivatives by registered funds. The proposal would require funds investing in derivatives in excess of certain levels to adopt a program to oversee their derivatives, monitor the risks associated with those derivatives, and protect the fund and its shareholders from unexpected losses due to those derivatives, which the Commissioners noted in their remarks was of particular concern for funds owned by retail investors.
While the new proposal pertains to registered funds investing in derivatives, it reflects the Commission’s ongoing concern with investors’ exposure to derivatives and leverage (particularly retail investors.) In May 2015 the SEC proposed amendments to Form ADV that would require additional disclosure of the use of derivatives and leverage in separately managed accounts.
Many years ago derivatives were easily identified, but today the exposure can be indirect and difficult to detect. Many popular mutual funds and exchange-traded funds have significant exposure to derivatives, hence the SEC’s proposal. For compliance officers to be effective they MUST understand the business risks at their firm. This is a good opportunity to review a list of consolidated holdings (which would be requested in a regulatory examination) with the investment committee or advisers at your firm. Share the proposed regulation and discuss your firm’s exposure. A detailed discussion of assessing the risk of derivatives is beyond the scope of this article, however, opening a dialogue is a good first step. Core Compliance can help you understand and assess the risk of derivatives. If you have questions or would like to learn more about derivatives contact us at (619) 278-0020 to schedule a consultation.