1/23/19 - Promontory Currents: SEC Announces Examination Initiatives for Mutual Funds and ETFs
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1/23/19 - Promontory Currents: SEC Announces Examination Initiatives for Mutual Funds and ETFs

By Jane Jarcho, Conway Dodge, Michael Sullivan, and Michael Vorhis

On Nov. 8, 2018, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) announced risk-based examination initiatives for registered investment companies (RICs),1 which focus on risk indicators for the products most commonly used by retail investors: mutual funds and exchange-traded funds. The extensive risk areas OCIE identified indicates its heightened attention to RICs. OCIE periodically publishes its examination priorities, such as these RIC-related initiatives, to promote transparency of its examination program and enhance compliance by highlighting heightened risks to investors or the integrity of the U.S. capital markets.

The examination initiatives focus on the following categories of risk indicators:

  1. Index funds
  2. Thinly traded ETFs
  3. Aberrational underperformance
  4. Securitized assets
  5. Registered investment advisers (RIAs) that are new to RICs
  6. Side-by-side fund management

RICs and RIAs should anticipate that, in 2019, OCIE examinations will focus on compliance policies and procedures; disclosures, controls, and oversight processes in place to mitigate risk; potential conflicts of interest that could harm retail investors; and board oversight of these risk areas.

1. Index Funds

Traditionally, index funds have tracked the S&P 500 or other well-known market indexes. OCIE appears to be concerned by the growing use of custom indexes developed and maintained by third-party index providers and, specifically, the nature of such index providers’ services. Specific areas of examination may include portfolio management, including whether portfolio management is consistent with disclosures; initial construction and ongoing maintenance of an index; advertisement of back-tested index returns; and potential conflicts of interest between an index provider and the fund’s RIA, including whether the index provider and RIA are affiliated.

2. Thinly Traded ETFs

OCIE also appears to be concerned about disclosures, controls, and oversight of ETFs with low secondary-market trading volume. Smaller and thinly traded ETFs are generally more volatile and subject to rapid price declines as they approach relevant exchanges’ thresholds for delisting. Examinations will likely focus on the following areas (when applicable): disclosures of liquidation-related risks and the associated costs to investors, policies and procedures, and board oversight of liquidation concerns. For recent ETF liquidations, examinations are likely to focus on the liquidation process, including the role of the fund’s board and adherence to the fund’s procedures for delisting and liquidating fund assets. 

Although OCIE explicitly relates these concerns to ETFs that pose the greatest risk of liquidation, all ETFs should consider whether their policies, procedures, and control processes adequately address the challenges outlined in this category of risk indicators.

3. Aberrational Underperformance

OCIE will also examine mutual funds that underperform relative to their peer group, likely focusing on whether portfolio-management processes and advertisements are consistent with disclosed investment objectives. In addition, OCIE will review board oversight of, and policies and procedures for, portfolio management.

4. Securitized Assets

OCIE also seems to be concerned by mutual funds with a relatively high concentration of securitized assets, such as securitized auto, student, and credit card loans and mortgage-backed securities. In addition to board oversight of portfolio management, OCIE will focus on disclosures related to these higher-risk assets, as well as policies and procedures related to asset quality and liquidity, valuation, and the pricing of assets that are illiquid or difficult-to-value.

5. RIAs that Are New to RICs

Related to its concerns driving its initiative to examine RIAs that are newly registered or that have not been previously examined, OCIE is also concerned about whether RIAs that enter the RIC market have the requisite knowledge, experience, and resources to design and operate an effective compliance program. As a result, it will evaluate the effectiveness of the funds’ boards and the compliance programs of both RICs and RIAs, and it will focus on compliance with RIC-specific marketing and distribution requirements.

6. Side-by-Side Fund Management

OCIE is concerned about conflicts of interest that may arise when RIAs provide similar investment advice to both RICs and private funds, known as “side-by-side” management. In particular, OCIE is concerned that RICs may be at a disadvantage in these situations. OCIE examinations will therefore focus on how RIAs address conflicts of interest arising from side-by-side management consistent with their fiduciary duties, including procedures and controls to ensure that investment opportunities, fees, and expenses are allocated fairly.


Jane Jarcho is a special adviser in Promontory’s asset-management practice. Conway Dodge and Michael Sullivan are managing directors, and Michael Vorhis is a principal, in Promontory’s Washington office.


1. “Risk-Based Examination Initiatives Focused on Registered Investment Companies,” Securities and Exchange Commission (Nov. 8, 2018).