Funds Need Better Derivatives Disclosure

Earlier this year the SEC staff commenced a review to evaluate the use of derivatives by mutual funds, exchange-traded funds and other investment companies, including, among other things, whether existing prospectus disclosures adequately address the particular risks created by derivatives.  In a July 30, 2010 letter to the Investment Company Institute, the SEC staff indicated that the initial results of its review are not encouraging.

It found that funds are providing generic disclosure about derivatives that is not adequately tailored to the specific investment strategies of the fund and does not emphasize the specific types of derivatives used by the fund, the extent of their use and the purpose of using derivatives transactions.  As a result, investors may not be receiving the disclosure they need in order to understand the risks associated with their investment in a fund.  The staff urged all funds that use derivatives to assess the accuracy and completeness of their disclosure, tailor their disclosure to include a description of the fund’s expected uses of derivatives and their relative importance and ensure that such disclosure is presented in an understandable manner using plain English.

Although the staff’s letter only addresses the disclosure provided by registered investment companies, hedge funds and other private funds are subject to anti-fraud principles requiring them to disclose all material information to investors and, therefore, should also take into account this guidance when preparing derivatives-related disclosure.