KEY TAKEAWAYS

  • US mutual funds will be subject to a new SEC rule governing the use of derivatives and certain financing transactions.
  • The new rule takes effect in August 2022, but will require time to implement.
  • Many funds will need to develop a derivatives risk management program and designate someone to administer it.
  • The new rule transitions from an obligations-based asset “coverage” approach to a Value at Risk (VaR)-based approach.
  • VaR uses a model to estimate the magnitude and frequency of potential future losses.
  • Funds will select the type of VaR limit that is appropriate for their strategy and instruments.
  • Western Asset has already started assisting clients to help them prepare to satisfy the new Rule’s requirements.

Rule 18f-4 Changes for US Mutual Funds

On October 28, 2020, the US Securities and Exchange Commission (SEC) adopted Rule 18f-4, which governs the use of derivatives and certain financing transactions by US mutual funds. The Rule emerges after almost a decade of gestation, and changes a framework that has been in place for decades.

The changes are a significant shift. Among other things, the Rule introduces “Value at Risk” (VaR) as a key component to limit fund derivative activity, replacing the prior asset coverage approach as the primary means of limiting leverage and mitigating derivatives risk. Compliance guidelines, governance and oversight stemming from the accompanying derivatives risk management programs will take time and effort to address. Mutual funds must comply by August 19, 2022.

Developing Derivatives Risk Management Programs

Fund managers and advisers will need to digest the requirements and nuances of the new Rule, develop and work through a project plan and coordinate with their respective boards. This will take a collaborative approach across disciplines. The lengthy implementation period established by the SEC recognizes the complexity and labor involved.

An officer of a fund or the fund’s adviser must be designated as a “derivatives risk manager” to administer a holistic derivatives risk management program at the fund level to address a variety of derivatives risks including market risk, liquidity risk, counterparty risk, operational risk and legal risk. Assigning someone with the requisite expertise and getting them involved in planning will be a priority.

Funds with only modest derivatives exposure (as measured by limits prescribed by the Rule and defined as “limited derivatives users”) will be required to adopt and implement policies to address derivatives risk, but will be exempted from the full requirements of the Rule. All other funds are subject to the full Rule requirements, including a full derivatives risk management program and VaR limits.

The Rule includes a new definition of derivative transactions. The new definition expressly prescribes that instruments a fund does not intend to settle physically or that take longer than 35 days to settle now qualify as derivatives. This will likely expand the scope of funds subject to the full Rule requirements beyond those funds that traditionally view themselves as active derivatives users.

In addition, funds that utilize reverse repurchase agreements and similar financing transactions also have the option to either meet traditional asset coverage requirements for all such transactions or may elect to treat such transactions as derivatives subject to the requirements of the Rule.

What Is Value at Risk?

Risk professionals typically use VaR to indicate the magnitude of potential losses a fund can expect and how often different loss levels are expected to occur over a specified time frame. VaR estimates potential future results of the current fund holdings. VaR calculations can be run on a single holding and also on a portfolio as a whole.

Exhibit 1: Probability Distribution of Portfolio Returns
Explore Probability Distribution of Portfolio Returns
Source: Western Asset.

VaR uses statistical calculations to show a level of expected loss with a certain degree of confidence. For example, VaR might indicate that a fund has a 99% percent confidence level that losses will not exceed 5% in a month. The 5% number is the absolute VaR.

Relative VaR compares the absolute VaR of the portfolio or holding to a benchmark or reference portfolio. It is also expressed as a percentage, so a portfolio with a relative VaR of 200% has an absolute VaR twice as high as its point of comparison.

Thinking Ahead to Implementing Value at Risk Limits

Addressing VaR limits is the most complex aspect of the Rule. Ownership, design and validation of the VaR model and selection of the limits that will apply are key decision points. Whereas asset coverage methodologies and calculations have traditionally been the province of compliance professionals, the move to a VaR framework will incorporate risk professionals into the fund compliance program.

Each fund (other than any fund that is a limited derivatives user) will utilize a VaR model to monitor limits. The Rule also requires regular back-testing to ensure the VaR model reasonably reflects actual gains or losses. VaR models can emphasize different factors and estimate future behavior in different ways. Model design decisions can vary depending on fund holdings, often based on availability of historical information and the complexity of instruments. A fund can build and maintain its own model, rely on a sub-adviser or engage a third party as long as it meets the provisions of the Rule.

Exhibit 2: Determining the Appropriate Value at Risk (VaR) Approach
Explore Determining the Appropriate Value at Risk (VaR) Approach
 

The Rule puts the burden on the fund to make decisions for which VaR approach is appropriate for a particular fund. The Rule generally requires that a fund use relative VaR, select an appropriate comparison benchmark or reference portfolio and be subject to a 200% limit for open-end funds. If relative VaR would not be appropriate in light of the fund’s strategy and instruments, a fund can opt to utilize absolute VaR. In that case, an open-end fund would be subject to a 20% absolute VaR limit.

Closed-end funds have a slightly different framework and need to plan accordingly. Closed-end funds with outstanding shares of a class of senior security that is a stock are subject to 250% relative VaR or 25% absolute VaR limits. The distinction for closed-end funds recognizes that the senior securities would raise a fund’s VaR even before taking into account any holdings or derivatives use.

Funds will need to analyze the relative and absolute VaR options, consider what is appropriate, and make a selection. While a fund can change its selection based upon a methodical assessment, these elections are not designed to be changeable on a day-to-day basis. There will be no ability to shift mid-day between options.

Funds will also need to plan for instances when a fund exceeds the VaR limits, including researching and validating overages and potential corrective action. Funds will need to keep in mind that outputs depend directly on the quality of inputs. Variations among models or exceptions produced by models may be explained by instrument set-ups rather than model designs or methodology.

Limited derivative user funds will also require an ongoing monitoring mechanism to confirm the fund remains below the applicable criteria of derivative use addresses overages by either remediating or implementing a full derivatives risk program and complying with all Rule 18f-4 provisions.

Western Asset’s Approach

Western Asset presently utilizes VaR in its risk management activities. It also manages commingled UCITS funds with VaR regulatory limits. Western Asset expects this experience to be helpful in working through Rule 18f-4 with its US mutual fund clients.

Rule 18f-4 applies at the fund level so it will not apply directly to Western Asset. Of course, in its role as sub-advisor, Western Asset will apply its normal portfolio management risk approach, but as a regulatory matter, it cannot build a derivatives risk management program to meet Rule 18f-4 specifications nor can it designate a derivatives risk manager under the Rule. A considerable open question is that of roles and responsibilities for VaR limit monitoring. Different mutual fund families might have different approaches and perspectives. Western Asset expects to have the capability to maintain a VaR model and monitor VaR limits. However, mutual fund clients may wish to maintain and administer their own VaR models. For example, mutual fund complexes with multiple funds and sub-advisers may desire consistency across all of their funds. Both approaches have trade-offs and implications for model design and administration, day-to-day monitoring and remediation (if and when needed). Western Asset expects to engage on these points with its mutual fund clients during their Rule 18f-4 implementation process. (For more information, please see the Appendix.)

An internal Western Asset working group is evaluating the Rule and its implications. Western Asset expects to work with its mutual fund clients to offer its perspectives through the process of selecting appropriate VaR approaches and reference portfolios where applicable. For example, Western Asset may be able to provide assessments of whether portfolios would qualify as limited derivatives users or how different VaR approaches might have operated in various market environments. In addition, Western Asset’s risk professionals have deep experience in operating VaR models, so the Firm may be able to help mutual fund clients to validate and assess their models.

Western Asset expects to conduct in-house monitoring, even if not for official Rule purposes. Funds intending to remain below the threshold for a limited derivatives user will be monitored (designation of instruments that qualify as derivative transactions is an aspect of that monitoring). Funds with VaR limits will be monitored based on their particular relative and absolute VaR elections. Those choosing relative VaR may have different reference portfolios, even for similar strategies.

Learning More

Additional commentary is available for readers interested in learning more:
  • Looking Ahead—Observations and Open Questions
  • VaR Basics
  • Regulatory History of Coverage and the Path to Using VaR
  • Rule 18f-4 VaR Limits and Limited Derivatives Users
  • Western Asset’s Use of Derivatives
  • Appendix—Value at Risk Model Ownership and Administration