SEC Division of Examinations Issues Mutual Funds, ETF Risk Alert

NOV 09, 2021 | PRACTUS LLP

SEC Division of Examinations Issues Mutual Funds, ETF Risk Alert

Authored by Karen A. Aspinall

Introduction and Overview

On October 26, 2021, the Division of Examinations (DEX) of the Securities and Exchange Commission (SEC) issued a Risk Alert reflecting its review of mutual funds and exchange-traded funds (collectively, funds) to assess industry practices and regulatory compliance in certain areas that may have an impact on retail investors (Funds Risk Alert).  The Funds Risk Alert highlights observations from recent DEX examinations of over 50 fund complexes and is intended to highlight risk areas and assist funds and their advisers in developing and enhancing their compliance programs and practices.

The DEX examinations were announced in a previous Risk Alert in November 2018 and focused on funds and/or their investment advisers (advisers) that fell into one or more of the following six categories: 

  • index funds that track custom-built indexes; 
  • smaller exchange-traded funds (ETFs) and/or ETFs with little secondary market trading volume; 
  • mutual funds with higher allocations to certain securitized investments; 
  • mutual funds with aberrational underperformance relative to their peer groups; 
  • mutual funds managed by advisers that are relatively new to managing such funds; and 
  • advisers that provide advice to both mutual funds and private funds, both of which have similar strategies and/or are managed by the same portfolio managers.


Regardless of the focus area(s) of the examined fund or fund complex, each examination included an assessment of:

  • the effectiveness of the compliance policies and procedures of the funds and their advisers to address certain risks – particularly with respect to disclosures, portfolio management compliance, and conflicts of interest – and the efficacy of fund boards’ oversight of funds’ compliance programs;
  • fund disclosures to investors in their prospectuses and other filings and shareholder communications, and adviser disclosures to the funds’ boards, regarding risks and conflicts in the focus areas; and 
  • fund governance practices, particularly as they pertain to the deliberative processes utilized by funds and funds’ boards when exercising oversight of funds’ compliance programs and assessing the practices and controls related to risks in the focus areas.

1. DEX Staff Observations:  

DEX staff found an array of deficiencies and weaknesses related to funds’ and advisers’ compliance programs for portfolio management as well as other business practices, as well as deficiencies and weaknesses related to board oversight of funds’ compliance programs.

a. Funds and Advisers With Procedures that Failed to Address their Business Model:  

DEX staff uncovered inadequate policies and procedures in the following areas:

  • Compliance Oversight of Investments and Portfolios 
    • Monitoring for portfolio management compliance, including monitoring compliance requirements regarding trade aggregation, trade allocation and best execution, and senior securities and asset segregation.
    • Monitoring for adherence to each fund’s specific investment restrictions (e.g., investment concentration restrictions, limitations on investments in alternative investments, and/or restrictions on lower-rated securities). 
    • Monitoring for the specific risks associated with each fund’s investments such as asset classes that present certain operational or other risks. 
    • Monitoring portfolios for compliance with the Fund Names Rule (Rule 35d-1 under the Investment Company Act of 1940 (1940 Act)), as applicable. 
    • Addressing the administration of each fund’s liquidity risk management program (LRMP) and providing appropriate oversight of third-party vendors providing liquidity classifications of holdings for purposes of a fund’s LRMP.
    • Providing appropriate oversight of the viability of smaller and/or thinly traded ETFs and oversight of their liquidation, as applicable, including communications with their shareholders. 
  • Compliance Oversight of Valuation 
    • Maintaining an adequate compliance program for valuing portfolio securities, including processes, controls, or both, that provide for due diligence and oversight of pricing vendors that provide evaluated prices for portfolio holdings in order to calculate the funds’ daily net asset values.
    • Maintaining appropriate policies, procedures and/or controls for valuing portfolio securities, including provisions that address potential conflicts and issues, such as where portfolio managers are permitted to provide input – as voting members of the valuation committee – on prices of securities in funds they managed.
  • Compliance Oversight of Trading Practices
    • Addressing appropriate trade allocation among client accounts so that all clients are treated fairly, including instances where trades for fund clients are aggregated with trades for other client accounts, including sub-advised funds, wrap accounts, and other non-wrap client accounts.
    • Preventing prohibited principal transactions with affiliates, prohibited joint transactions with affiliates, or both.
    • Identifying cross trades and preventing related violations of the legal requirements for cross trading and principal trading under the Investment Advisers Act of 1940 (Advisers Act) and the 1940 Act.
    • Addressing sharing of soft dollar commissions among clients to assess whether any client is disadvantaged.
PRACTUS NOTE:  Assessing the sharing of soft dollar commissions among clients to assess whether any client is disadvantaged may sound simple, but is fiendishly difficult to perform in reality.  In the first instance, Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for an investment manager to utilize commission dollars generated from one account to purchase research that will benefit other accounts managed by that manager.  Moreover, SEC staff no-action letters permit accounts subject to the restrictions on the use of brokerage commissions to purchase research imposed by MiFID II to pay execution-only rates on aggregated trades, even as other accounts not subject to these restrictions pay full service commissions (commissions for both execution and research).  Finally, as other commenters have previously advised the SEC, an ability to quantify and allocate the benefits of research acquired with soft dollars is not realistic because managers cannot quantify and allocate the benefit of an insight on a particular security among numerous clients that may be, to a greater or lesser extent, able to invest in that stock.
  • Compliance Oversight of Conflicts of Interest
    • Addressing advisers’ conflicts of interest with funds and their service providers, such as certain “dual capacity” instances where the adviser to an index fund also acts as the index provider.
    • Reviewing index providers and the services they provide for, among other things:  (1) conflicts of interest with advisers, such as when they share personnel, are affiliated, and/or have business arrangements (e.g., marketing support payments by index providers to advisers and/or revenue sharing payments by advisers to index providers); and (2) the sharing, or the potential misuse, of material non-public information.
  • Compliance Oversight of Fees and Expenses
    • Monitoring allocation of expenses between funds and their advisers, subject to any fee waivers by the adviser.
    • Reviewing fee calculations for any inconsistencies between a fund’s contractual expense limitation and its disclosures regarding expenses included in operating expenses, subject to the expense cap.
PRACTUS NOTE:  The genesis of the observation regarding inadequate policies and procedures to monitor the allocation of expenses between funds and their advisers, subject to any fee waivers by the adviser, appears to be a similar observation made in the 2020 Private Fund Adviser Risk Alert.  However, what is simply an allocation and disclosure point in the private fund world can be a prohibited joint transaction in the registered fund world.  We would caution funds and advisers to ensure that any such allocation complies with Section 17(d) and Rule 17d-1 under the 1940 Act, even if the Funds Risk Alert did not address the joint transaction implications of these expense allocations.
  • Compliance Oversight of Fund Advertisements and Sales Literature
    • Reviewing and filing fund advertisements and sales literature, including review of fee and expense disclosures to assess whether they are fair, balanced and not misleading within the context in which they are made, and, as applicable, the presentation of backtested index returns (e.g., the characteristics of back tested index returns when compared to a fund’s actual returns).
    • Reviewing affiliated index providers’ websites – accessible through hyperlinks in the statements of additional information (“SAIs”) of self-indexing funds – to assess whether the websites may be deemed fund sales literature that should be filed with the Commission or FINRA

b. Funds With Inadequate Board Compliance Oversight Procedures:  

DEX staff observed issues with funds’ policies and procedures for their boards’ oversight of the funds’ compliance programs. For example, the staff observed funds that did not:

  • Have appropriate policies, procedures and processes for monitoring and reporting to their boards with accurate information, such as information regarding:
    • fees paid by the funds to financial intermediaries and other service providers for providing shareholder services; 
    • the type of services provided by service providers; 
    • pricing exceptions under the funds’ valuation policies and procedures; 
    • adviser’s recommendation whether a fund’s liquidation may be in the best interests of the fund and its shareholders; and 
    • portfolio compliance with senior securities and asset coverage requirements.
  • Provide appropriate processes as part of the board’s annual review and approval of the fund’s investment advisory agreement under Section 15(c) of the 1940 Act regarding the board’s considerations as to whether the adviser has any financial condition that is reasonably likely to impair its ability to meet its contractual commitments to clients.
  • Complete required annual reviews of the funds’ compliance programs that address the adequacy of policies and procedures and effectiveness of their implementation.
  • Ensure that the annual report from the fund’s chief compliance officer addressed the operation of the policies and procedures of the fund’s adviser, including whether the adviser had policies and procedures in specific risk areas.
  • Adopt or maintain appropriate policies and procedures for the funds’ boards to exercise appropriate oversight in instances where the funds’ delegated responsibilities to their advisers were not reflected in the advisers’ compliance programs.

c. Deficient Disclosures to Investors

DEX staff found various deficiencies or weaknesses observed by the staff related to the funds’ disclosures to investors in fund filings, advertisements, sales literature and/or other shareholder communications.

  • Inaccurate, incomplete and/or omitted disclosures in their filings, including:
    • Omitted disclosures regarding: (1) certain principal investment strategies and/or risks of investing in the funds; (2) potential conflicts associated with allocating investment opportunities among overlapping investment strategies; and (3) change in the broad-based indexes used for comparison of funds’ performance.
    • Inconsistent and/or inaccurate disclosure concerning the funds’ net assets and net expense ratios, contractual expense limitations, and/or operating expenses subject to the contractual expense limitation.
    • Failures to disclose in the funds’ SAIs (i) required information concerning standing committees of a fund’s board and (ii) accurate information regarding the number of accounts and total assets managed by the portfolio managers within each of the required categories.
  • Funds with inaccurate, incomplete, and/or omitted disclosures regarding various advertising and sales literature-related topics, such as:
    1. investment strategies and portfolio holdings;
    2. the differences in investment objective(s) between predecessor and successor funds;
    3. inception dates;
    4. funds’ expenses, contractual expense limitations, and/or expense ratios;
    5. average total returns and/or gross expenses and net expenses;
    6. performance information not disclosed with the required legends;
    7. awards received for fund performance;
    8. weighting of index constituents in the benchmark index;
    9. methodologies for calculating the performance of the benchmark index;
    10. differences in holdings, risks, and volatility between the broad-based and bespoke indexes used for performance comparisons; and/or
    11. composition of any index used for performance comparisons.

2. Staff Observations of Effective Practices 

DEX staff identified various practices with respect to funds’ and their advisers’ compliance programs, boards’ oversight of funds’ compliance programs, and disclosure practices that funds and their advisers may find helpful in their compliance oversight practices. 

  • Certain funds and their advisers adopted and implemented compliance programs that provided for:
    • Review of compliance policies and procedures to assess whether they conformed with practices (e.g., funds reviewed their advisers’ compliance manuals for specific policies and procedures addressing various risk areas for which the funds had delegated responsibility to their advisers).
    • Conducting periodic testing and reviews for compliance with disclosures (e.g., review whether funds are complying with their stated investment objectives, investment strategies, restrictions, and other disclosures) and assess the effectiveness of compliance policies and procedures in addressing conflicts of interests (e.g., review trade and expense allocation policies and procedures in light of potential conflicts that may exist among the various types of accounts managed by the adviser).
    • Ensuring compliance programs adequately address the oversight of key vendors, such as pricing vendors (e.g., written pricing vendor oversight processes include reviewing variance reports on stale or outlier prices and price challenges).
    • Adopting and implementing policies and procedures to address: (1) compliance with applicable regulations (e.g., to identify cross trades, where applicable, and prevent related violations); (2) compliance with the terms and conditions of applicable exemptive orders and any disclosures required to be made under the order; and (3) undisclosed conflicts of interest, including potential conflicts between funds and/or advisers and their affiliated service providers.
  • Certain funds’ boards provided oversight of funds’ compliance programs by assessing whether:
    • The information provided to the board was accurate, including whether funds’ and their advisers were accurately disclosing to the boards: (1) funds’ fees, expenses and performance, and (2) funds’ investment strategies, any changes to the strategies, and the risks associated with the respective strategies.
    • The funds were adhering to their processes for board reporting, including an annual review of the adequacy of the funds’ compliance program and effectiveness of their implementation.
  • Certain funds adopted and implemented policies and procedures concerning disclosure, such as those that required:
    • Review and amendment of disclosures in funds’ prospectuses, SAIs, shareholder reports or other investor communications consistent with the funds’ investments and investment policies and restrictions;
    • Amendment of disclosures for consistency with actions taken by the funds’ boards.
    • Update of funds’ website disclosures concurrently with new or amended disclosures in funds’ prospectuses, SAIs, shareholder reports or other client communications.
    • Review and testing of fees and expenses disclosed in funds’ prospectuses, SAIs, shareholder reports or other client communications for accuracy and completeness of presentation.
    • Review and testing of funds’ performance advertising for accuracy and appropriateness of presentation and applicable disclosures.

3. Conclusion

While the DEX staff’s examination were limited to funds (and their advisers) that fell into one of the six areas of focus, the deficiencies found are by no means unique to those funds.  For that matter, a majority of the deficiencies, and a majority of the effective practices, apply with equal force to closed-end funds.  Consequently, we believe that few, if any, registered investment companies or their advisers can afford to ignore the Funds Risk Alert.

However, we also believe that the Funds Risk Alert does not represent the final word on fund and adviser compliance obligations.  The very first page of the Funds Risk Alert notes that:

The views expressed herein are those of the staff of the Division of Examinations, formerly known as the Office of Compliance Inspections and Examinations or OCIE (the “Division”). This Risk Alert is not a rule, regulation, or statement of the Securities and Exchange Commission (the “SEC” or the “Commission”). The Commission has neither approved nor disapproved the content of this Risk Alert. This Risk Alert has no legal force or effect: it does not alter or amend applicable law, and it creates no new or additional obligations for any person. This document was prepared by Division staff and is not legal advice.

As we note earlier, we believe that there are instances in which the Funds Risk Alert may not fully reflect the current understanding of an adviser’s fund compliance obligations or the current understanding of applicable law.  In these instances, we believe it is best for an adviser or fund to document what its current compliance control(s) is/are, how it differs from the corresponding recommendation of the Funds Risk Alert, and why the adviser or fund believe that their control(s) are reasonably designed to prevent violations of the relevant federal securities law(s). 

Please contact the Practus attorney with whom you normally work with any questions regarding this Legal Insight.  

The Authors
Karen A. Aspinall
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Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.

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