Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

SEC warns on hedged mutual funds

Andrew Bowden
Source: SEC | Flickr

A top financial regulator has issued a warning about the rapidly growing segment of mutual funds that mimic more complicated hedge fund strategies.

"Alternative funds are the bright, shiny object. But they're a sharp object," Andrew Bowden, director of the Securities and Exchange Commission's Office of Compliance Inspections and Examinations, said during a speech at an investment advisor conference Thursday.

"The use of market valuation for illiquid securities in an open-ended mutual fund, which requires daily valuation and offers daily liquidity is fraught with risk," Bowden said. "If any of you are considering launching a mutual fund that uses alternative investments or strategies, I implore you to evaluate the reasonableness and the effectiveness of your controls."

Hedged mutual funds growing

The comments were first reported by InvestmentNews. An SEC spokeswoman said the agency does not confirm reported quotes but that the general message was correct.

(Read more: Now mutual funds are poaching from hedge funds)

The remarks surprised at least one observer.

"I'm a little perplexed the SEC is ringing the bell on this," said Josh Charney, a Morningstar analyst who tracks alternative mutual funds.

"Most large 40 act funds (created by the Investment Company Act of 1940 that governs such funds) are highly liquid, especially those that focus on stocks. There are more important areas to sound the alarm on alternative mutual funds over, such as nontransparent derivative exposure," he added.

Mutual fund rules mandate that no more than 15 percent of assets can be in illiquid securities. And the funds must price daily so that they can be traded at virtually anytime.

Assets in open-ended alternative mutual funds totaled $142 billion as of January 2014, according to Morningstar. That's up 44.3 percent from a year before. A majority of the assets are technically in bond funds, but most of the strategies that attempt to mimic hedge funds are equity focused.

(Read more: Sackler family makes $100M bet on low fees with Balter fund)

Bowden's comments aren't the first time the SEC has addressed risks in hedged mutual funds. At a presentation to fund chief compliance officers on Jan. 30, SEC officials noted liquidity, valuation and compliance as "risks" and "considerations" for alternative mutual fund managers to note.

YearNo. of fundsYear-End Net Assets ($B) 200821336 200923847 201027863 201132676 201237591 2013411132

Regardless of the warning, liquid alternatives are on the rise. A recent report by Barclays' prime brokerage unit, "Going Mainstream," noted that assets under management have grown at an annualized rate of 33 percent versus 14 percent for hedge funds since January 2009.

The reasons, according to the report, include increased awareness of alternative strategies by retail investors and their advisors; concerns on how to protect portfolios from market drops; improving perceived quality of products, especially from brand-name hedge fund managers; and more obvious benefits of liquidity, transparency and lower fees.

—By CNBC's Lawrence Delevingne. Follow him on Twitter @ldelevingne.

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