OCIE Risk-Based Examination Initiatives Focused on Mutual Funds

November 19, 2018

On November 8, 2018, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (“OCIE”) issued a National Exam Program Risk Alert announcing its 2019 examination initiatives focused on matters relevant to mutual funds and exchange-traded funds (“ETFs”).1  These initiatives illustrate OCIE’s continued commitment to examining matters important to retail investors, as mutual funds and ETFs are their primary investment vehicles. Here we focus on the mutual fund initiatives.

During examinations, OCIE staff will look at the activities of mutual funds and their advisers, as well as the oversight exercised by the mutual funds’ boards of directors. Except for the side-by-side management of mutual funds and private funds, all the examination areas described below are carryovers from OCIE’s 2018 examination initiatives.

Index Funds that Track Custom-Built Indexes

Custom-built indexes are created and/or maintained for the exclusive use of a single mutual fund or mutual fund sponsor and used to select a mutual fund’s investments, which may allow that mutual fund to pursue a more complex investment strategy than a traditional index-tracking mutual fund. During examinations, OCIE staff will:

  • evaluate the risks and challenges unique to mutual funds with custom-built indexes and the adviser and index provider roles as they relate to index component selection and weighting, ongoing index administration, mutual fund management, and related performance advertising;
  • review how the portfolio is managed compared to the mutual fund’s investment strategy disclosures;
  • determine the services provided by the index providers and the adequacy of disclosures made to the mutual fund’s board of directors regarding these providers;
  • assess whether conflicts of interest between the index providers and advisers are appropriately addressed; and
  • review the effectiveness of a mutual fund’s compliance program for portfolio management and board of director oversight.

Aberrational Underperformance Relative to their Peer Groups

In these instances, OCIE staff will seek to understand the factors behind the mutual fund’s aberrational underperformance relative to its peer group, including its asset allocation and security selection processes. As part of this effort, the staff will review the effectiveness of the fund’s compliance program and determine whether its board of directors is exercising appropriate oversight. The staff will focus in particular on portfolio management processes, including whether the mutual fund or its adviser is:

  • investing in a manner consistent with the mutual fund’s disclosed investment objective and/or investment strategy; 
  • using advertising and marketing materials that contain complete and accurate statements related to the fund’s investment objectives, policies, risks, and/or restrictions; 
  • allocating investment opportunities to the fund in a manner consistent with the adviser’s fiduciary duty; and 
  • adhering to applicable requirements when borrowing or investing the mutual fund’s portfolio in instruments that may leverage the fund.

Higher Allocations to Certain Securitized Assets

A mutual fund investing in certain securitized assets (e.g., securitized auto loans or mortgage-backed securities) may expose retail investors to risks that may not be adequately disclosed to them or risks not anticipated by the fund’s adviser given potential changes in market conditions and unexpected market stresses. During examinations, OCIE staff will assess whether the mutual fund and/or its adviser have appropriate:

  • policies, procedures, and practices, and related oversight, specifically those addressing portfolio management activities and investment risks; 
  • portfolio management activities, including risk identification, monitoring, and mitigation practices to evaluate how the adviser manages the fund’s portfolio holdings and liquidity; 
  • valuation and pricing policies and procedures that include the fund’s pricing practices and use of vendors, especially regarding illiquid securities and other securities or asset classes that can be difficult to value; 
  • governance and board of director oversight practices, particularly those for pricing and valuation; and 
  • disclosures to investors, especially with respect to investment risks.

Side-by-Side Management of Mutual Funds and Private Funds

During prior examinations, OCIE identified conflicts of interest associated with advisers that provide advice to mutual funds and private funds, particularly when the funds are managed according to similar strategies and/or by the same portfolio managers. Such conflicts may present risks to retail investors. During examinations, OCIE staff will evaluate an adviser’s:

  • policies and procedures for addressing conflicts of interest and other risks associated with side-by-side management, particularly those related to portfolio management and portfolio construction practices; 
  • controls for ensuring appropriate brokerage, best execution, and trade allocation practices, including trade aggregation and allocation of investment opportunities in a manner consistent with the adviser’s fiduciary duty; 
  • allocation practices for various fees and expenses; and 
  • disclosures to investors and the fund’s board of directors.

Mutual Funds Managed by Advisers Relatively New to Managing Such Products

Given that mutual funds operate under the Investment Company Act of 1940, advisers may lack experience or sufficient knowledge regarding the statute and its requirements. The resulting potential lack of adequate compliance support increases the risk of failing to comply with mutual fund-specific regulatory requirements, engaging in prohibited transactions, and/or omitting information that must be disclosed to investors. During examinations, OCIE staff will evaluate:

  • mutual fund governance to ensure the board of directors has sufficient information to perform its duties, 
  • the effectiveness of the adviser’s and the mutual fund’s compliance programs; and 
  • marketing and distribution efforts related to the mutual fund. 


With its risk alert, OCIE is giving mutual funds and their advisers and boards of directors a head start on reviewing, and possibly strengthening, their compliance programs. These entities should review each examination focus area for relevance to their business. For each area that is relevant, mutual funds and their advisers should (i) test the focus area; (ii) review risk and control matrices, policies, and procedures; (iii) enhance or begin personnel training in these areas; and (iv) review disclosures to shareholders and reporting to the board. They should also consider noting in detail in their annual compliance reports the steps they take to address these focus areas.

1 See “Risk-Based Examination Initiatives Focused on Registered Investment Companies,” November 8, 2018, available here. See also ACA Compliance Alert “OCIE Risk-Based Examination Initiatives Focused on ETFs” available here.