• Joe Farley

Where did Rule 18f-4 come from?

Section 18 of the Investment Company Act of 1940 (“40 Act”) covers the ability of investment companies to “issue or sell senior securities.” This is 1940’s speak for borrowing or LEVERAGE.

The Securities and Exchange Commission (“SEC” or “Commission”) regards any investment that represents an obligation to pay some amount in the future as “evidence of indebtedness.” Examples include written options, futures, forwards, and “certain other derivative transactions.” The player to be named later, if you will..


The initial fix for this indebtedness in 40 Act funds was for managers to segregate enough assets from the rest of the portfolio to cover the full face value, or notional amount, which would be due in the future. The SEC used the notional amount to restrict the use of these investments, stating that these segregated accounts could get so large it would affect a portfolio’s liquidity and make management difficult.


As the use of derivatives grew, the SEC issued a general policy statement in 1979 in a first attempt to clarify their position on the use of these transactions. Over the following years, the Commission issued over 30 additional no-action letters providing direction to managers for dealing with these issues.


Over time, the types and complexity of derivative investments has also increased. These complexities and the inter-connectedness of these investments made it difficult for portfolio managers to fully understand all the ways these investments could impact their portfolio, and almost impossible for the regulators.

Trying to manage these new and complex investments with a 30-year old patchwork of revisions to a 70-year old rule was one of many factors that led to the Great Financial Crisis of 2008-9.

Derivatives on derivatives backed by mortgage loans created a house of cards built on much smaller underlying investment values. When the values of the underlying investments fell, the house of cards collapsed. The leverage created from the derivatives amplified those losses to catastrophic levels.


With all of that in mind, the SEC began work on codifying its various policy statements and no action letters into a new sub-section, 18f-4. An initial draft was posted for comment in 2015. After the comment period, a new draft was developed and released in 2019. This version was eventually approved in 2021 and became effective August 2022.


The SEC decided to use a test of Value at Risk (“VaR”) for portfolio holdings including derivatives compared to the VaR of a benchmark portfolio or the portfolio minus the derivatives. The daily test results are compared to the portfolio’s actual change. If either the daily test or the daily back test fails, the results must be reported and cured within 5 days.

Now you may be wondering about leverage and why the SEC is concerned about it. It boils down to debt or borrowing. A fund can borrow against the value of the portfolio and use those funds to make additional investments.


Leverage is great when values are going up because it boosts the increases to portfolio values. However, leverage works the same way going down, amplifying losses, often even at a greater rate than when values are increasing. Probably not coincidentally, leverage was the cause of the greatest financial crisis to occur prior to 2008, The Great Depression - the event that led to the 40 Act.

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