Unconstrained Mutual Funds and Retail Investor Protection


The proliferation of unconstrained mutual funds (“UMFs”) — a subset of regulated mutual funds — calls into question the effectiveness of retail investor protections under the U.S. Investment Company Act of 1940 (the “Company Act”). My paper examines this issue. UMFs share several important investment strategy and risk attributes with private funds. These include broad authority to trade almost any type of security, including illiquid securities, take concentrated investment risks in individual securities, sectors, or markets, make extensive use of derivatives, engage in short selling, and change the duration of the portfolio without any effective limit. However, unlike private funds, which are generally limited to investors who satisfy particular investment sophistication and net worth requirements, shares of UMFs may be purchased by retail investors, including those with quite limited or no investment experience.

In the recent past, UMFs have proliferated because of their attractive characteristics in an otherwise challenging investment environment. Record-low interest rates, significant market dislocations, and retail investors’ persistent efforts to boost income and protect capital, have significantly increased the demand for UMFs in the last few years. In 2016, Morningstar categorized 448 mutual funds as involving some element of unconstrained or non-traditional characteristics. The popularity of UMFs can partially be traced back to their ability to pursue absolute returns in the fixed-income market without being affected by the constraints of conventional credit mutual fund benchmarks.

Like mutual funds, UMFs, are subject to the extensive regulatory requirements of the Investment Company Act of 1940, among many other legal requirements. In contrast with mutual funds and UMFs, private funds are generally not required to comply with the substantive requirements of the Company Act. This means, for example, that a private fund, unlike a UMF, need not: register with the SEC; register a class of shares with the SEC; provide periodic financial and individual portfolio holdings information to the SEC or to investors; comply with Rule 12b-1 regarding the use of fund assets to pay fund marketing expenses; comply with the requirement to strike a NAV on a daily basis; pay investor redemption proceeds within seven days; or limit its short selling or borrowing, including through the use of derivative contracts. Moreover, unlike for mutual funds (including UMFs), private funds are not required to have independent directors.

Compliance with the provisions of the Company Act means that UMFs may be marketed and sold to all classes of retail investors, including retail investors who have limited, or even no, experience investing in securities. Private funds, in contrast, are not marketed to retail investors. Instead, the opportunity to invest in a private fund is restricted to those who meet particular experiential and net worth investment criteria indicating that they are able to understand the risks associated with investing in the fund, including the risk that their investment could lose all or the greater part of its value. Because private fund investments are restricted to investors deemed to be sophisticated — a category that does not include the majority of retail investors — private funds generally are exempt from the registration and other substantive provisions of the Company Act.

Despite their legal treatment as mutual funds, UMFs share important investment strategy and risk attributes with private funds. UMFs use a higher proportion of derivatives than other mutual funds and follow instrument selection and trading strategies comparable to those employed by private funds. Like private funds, UMFs use dynamic trading strategies and derivative holdings to avoid parametric normal distributions. Because of their use of options, UMFs, like private funds, can generate options-like returns and exhibit non-normal payoffs. Moreover, the average portfolio turnover rate for UMFs suggests a level more consistent with the turnover rate of a private fund. The average turnover rate for a UMF exceeds the portfolio turnover rate for fixed income mutual funds by more than 150%. The turnover rate in UMF portfolios relative to that of other mutual fund portfolios suggests that UMFs trade at levels consistent with those of private funds. The higher UMF turnover rate relative to that of other mutual funds can be partially explained by the strategies pursued by UMFs, including the extensive use of derivatives among UMFs.

UMFs raise unique retail investor protection concerns. Factors that contribute to the retail investor protection concerns in the context of UMF investments include the growth in the number of UMF launches in combination with important investment strategy and risk attributes shared by UMFs and private funds. The “go anywhere” features of UMFs may impede a retail investor’s ability to ascertain and understand the UMF’s investments, and the risks associated with those investments. More specifically, the lack of standard benchmarks for UMFs, the recent emergence of UMFs as an investment asset type, and the diversity among and complexity of UMFs’ strategies and risk exposures make it uniquely challenging for retail investors to evaluate the risks of investing in UMF securities.

Retail investors may be led to believe that UMFs, because they are marketed, offered, and regulated as mutual funds, are “safe” products relative to other fixed income mutual funds. This is a risk that is unique to retail investors in UMFs: a private fund investor, who by definition is relatively more sophisticated and wealthier than a retail investor, would have no reason to believe that there is active government regulation of the private fund in a manner conceptually similar to what the SEC requires of mutual funds. Nonetheless, the mutual fund characteristics of a UMF may cause the average retail investor to conclude that the investor’s past experience selecting mutual fund investments for his or her personal portfolio will provide adequate grounding to understand the risks associated with purchasing UMF shares. Any such conclusion would be mistaken, as retail investors in UMFs face many of the same types of investment strategy and other risks as those faced by relatively more sophisticated and wealthier investors in private funds, a group whom the SEC has determined can “fend for themselves.” Accordingly, retail investors’ experience investing in “traditional” mutual funds is likely to be a poor indicator of whether a retail investor will understand the risks associated with investing in a UMF.

Wulf Kaal is Associate Professor and Director of the Private Investment Fund Institute at the University of St. Thomas School of Law.