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When Commodities Are Not An Option

Hungry for healthier returns, more mutual funds are investing in commodities, commodity futures, swaps and options.

In turn, regulators-particularly the Commodity Futures Trading Commission (CFTC)-are tightening oversight to try and make sure none play fast and loose with either the law or good marketing practices.

The core concern: A growing number of funds can skirt laws designed to cap their exposure to commodities.

"The mutual fund industry's $50 billion investment in commodity markets is continuing to grow and merits a cop on the beat with a focused interest in protecting commodity markets from wrongdoing," wrote Senator Dianne Feinstein, chair of the subcommittee on Energy and Water Development Appropriations and Senator Carl Levin, chair of the Senate Permanent Subcommittee on Investigations, in a November letter to the CFTC.

Besides over-exposure to commodities, regulators also fear inadequate disclosure of information about the brokers involved, known as futures commission merchants, or the performance of the funds that make the investments in commodities. Also unclear can be who is actually managing a fund, the fees being paid and the risks involved.

In some cases, according to the National Futures Association, funds market themselves to unsophisticated retail investors as commodity pools, when they are not registered as such. Others are, in the words of Levin, creating "offshore shams" to get around rules governing investments in commodities.

Partly as a result, the CFTC voted earlier this month to amend Rules 4.13 and 4.5 of Title 17 of the Code of Federal Regulations to make it significantly harder for mutual funds to avoid its purview. For instance, mutual funds now must register as commodity pool operators if they trade more than 5% of their liquidated asset value in speculative commodities trading.

Likewise, the Internal Revenue Service suspended in June its practice of writing ruling letters that allow these funds to set up offshore corporations and engage in a level of investing in commodities that, if they were operating back in the States, would violate Internal Revenue Code Section 851(b)(2), which prohibits an investment fund such as a mutual fund from putting more than 10% of its assets in alternative investments, including commodities.

Moreover, the Securities and Exchange Commission is expected to work more closely with the CFTC to search for fraudulent disclosure and marketing.

The commodities sector has seen an explosion in mutual fund activity, according to statistics prepared for a Jan. 26 hearing held by Levin's Senate Permanent Subcommittee on Investigations. In 2011, there were at least 40 funds investing more than $55 billion in the commodities market versus 2008, when there were five funds with less than $10 billion in assets placed in commodities-related financial instruments.

According to exhibits prepared for that hearing, managers included some of the biggest names in the industry, such as the Pacific Investment Management Company, which has nearly $25 billion in the sector and Fidelity Investments with more than $7 billion.

Other big names cited include OppenheimerFunds, Goldman Sachs Group, Credit Suisse and BlackRock. Niche players include Equinox Fund Management and AQR Capital Management.

None of these companies are the subject of federal investigations or enforcement actions, nor have they been accused of any wrongdoing, related to this issue.

Mutual fund activity in commodities grew, in part, due to relaxed regulation by both the CFTC and IRS.

For example, in 2003, the CFTC decided to loosen its rules related to registration, marketing and trading.

Before that decision, Investment Company Act of 1940 firms had to do a lot to avoid registering as a commodity pool operator with the agency.

For instance, they had to prove that their commodity and alternative trading was meant for hedging and show that any non-hedge investments did not exceed 5% of the liquidated value of their assets. The 2003 CFTC amendments eliminated those requirements, leading to a rapid influx of assets. The February 2012 amendments essentially tried to close the floodgate and subject any funds investing in commodities to greater scrutiny.

The IRS loophole started in 2006, when the tax agency started writing ruling letters allowing funds to use two strategies to outmaneuver its 70-year-old Code Section 851(b)(2), which-in exchange for tax breaks-limits registered investment company stakes in commodities to be no more than 10% of total assets.

The first strategy to get around that requirement involves using controlled foreign corporations to trade in commodities, as Senator Levin and his fellow investigations subcommittee member Tom Coburn wrote in a December letter to IRS Commissioner Douglas Shulman.

With such companies set up, a fund would book any income generated from trades as coming from the securities held in these shell companies. The trading wouldn't count towards the cap, according to Levin and Coburn in their letter.