Killing the Short/Short Rule
The new tax bill offers hope for mutual funds.
By Laurie Morse
With the explosion of mutual fund assets and all the new mutual fund
strategies to choose from, some retail investors on Main Street are beginning
to feel they're on equal footing with the big names on Wall Street.
That feeling, of course, is a grand illusion for many reasons. One of
the more obvious is that mutual funds are governed by an obscure piece of
tax legislation that discourages their managers from using mainstream risk-management
instruments and encourages them to avoid short-term capital gains.
The upshot is that mutual fund investors who control nearly $4 trillion
in assets are paying higher compliance costs than their wealthier counterparts,
are exposed to greater risks and are losing out on important income opportunities.
The rule, known variously as the 30 percent test or the "short-short rule," is contained in the Internal Revenue Service Code and requires
that mutual funds derive less than 30 percent of their gross income from
the sale of securities held for less than three months. The rule does not
apply to hedge funds, the pooled investment of choice for wealthy people.
Compliance with the rule means funds can pass on capital gains to investors without being taxed, and investors can claim their dividends as ordinary
income. Should a fund manager "blow up" the fund by creating too
much short-term income, the IRS taxes the fund's entire gain at the 35 percent
corporate tax rate, and also taxes dividends paid to shareholders at the
higher short-term capital gains rate.
The intent of the 60-year-old tax rule is obscure, but appears to have
been an attempt to discourage brokers from churning mutual fund accounts
and from speculating with small investors' dollars.
The penalty for creating "undesirable" income is so great that mutual fund managers go to great lengths, and expense, to monitor investments
to meet the 30 percent test. The Investment Company Institute, the trade
group for mutual fund companies, has long argued that the tax rule creates
substantial administrative complexity, and tax-motivated, rather than investment-motivated
behavior on the part of fund managers. The group advocates repeal of the
rule, saying tax treatment should be consistent across all pooled investment
The 30 percent test repeal is a perennial candidate for any new national tax bill. "I think most people recognize that this has no real economic
or policy justification," said Chris Wolszczyna, spokesman for ICI.
"Even Treasury seems to support its repeal, but for administrative
reasons, it hasn't gone through." Even with no real opposition, the
push to repeal has died twice on the President's desk, once in the Bush
administration and, in 1995, at the Clinton White House.
Now, legislative consultants expect a rollback of the tax law to be included in the tax bill expected to be introduced later this year. "If we get
a new tax bill, this will be a hot issue," says Clyde Ensslin, a consultant
with Washington-based Capital Market Perspectives. "You will hear more
about this, because restricting the (ability of mutual funds to hedge) has
no economic or public policy basis."
"There's great concern about how the middle class is impacted by
the new tax bill," says William Brodsky, Chairman and CEO of the Chicago
Board Options Exchange. "The good thing is that this specifically benefits
mutual fund holders, most of whom come from the 'middle class.'"
Brodsky says that although legislation eliminating the short-short rule
has not been a particularly controversial issue, Congressional supporters
have not been able to propose the short-short rule as a separate item. He
is now "cautiously optimistic" about attaching it to the tax legislation
now moving through Congress. "When the train leaves the station, we've
got to be on that train," he says.
That day can't come too soon for the Investment Company Institute. The
ICI says that in today's climate of takeovers and mergers the 30 percent
test has had an increasingly capricious impact on mutual fund operations.
In a recent report, the group noted that "One large gain, caused by
an unexpected tender offer or a dramatic price increase of a stock held
for less than 3 months can cause unforeseen violation of the provision."
To make matters worse, the test applies to the fund's gross gain, so losses
cannot be used to offset the gains that create the 30 percent test problem.
Mutual fund managers agree that the biggest single group of investments
affected by the 30 percent test is exchange-traded derivatives. Most futures
and options contracts have maturities of just three months, and unpredictable
income streams that could "blow up" a mutual fund with little
The 30 percent test "basically eliminates the use of exchange-traded derivatives in the vast majority of mutual funds," says David Mangefrida,
partner in the national tax department of Ernst and Young, "It is very
hard to justify the use of a derivative when the outcome could mean blowing
the status of the fund."
There are some limited exemptions to the test for hedge use of derivatives, but not a lot of people use them, says Mangefrida. They are too complicated,
and the IRS has offered little guidance on their application.
At a time when some of the biggest and most sophisticated money managers on Wall Street recognize the benefits of using derivatives for hedging and
asset allocation, it is hard to measure the costs of their exclusion in
mutual fund portfolios, he added.
MATIF Goes Out The Curve
By early Fall, France's MATIF will have revamped its debt futures and
options offerings to reflect the full yield-curve span of French government
securities. The exchange is re-orienting its debt futures and options strategy
to focus on long- and medium-term bonds-products that are expected to remain
lively even after EMU currency convergence in 1999.
For starters, specifications on MATIF's popular Notional bond futures
contract will be changed to bonds with a lower coupon and a truer long-term
maturity, and the final list of deliverable securities will be fixed just
one month ahead of expiration, rather than the current five months. Furthermore,
MATIF will require there be at least Ff 40 billion of a security outstanding
for it to qualify for delivery, an eight-fold increase from the current
minimum of Ff 5 billion.
The Notional's cheapest-to-deliver bonds currently tend to have remaining lives of just over seven years. After the revisions, which are effective
in September for the December 1997 contract, the eligible securities will
have maturities of 8.5 to 10 years. Deliverable coupons will be reduced
from 10 percent to 5.5 percent.
By making the Notional more closely reflect the long end of the French
yield curve, the exchange can make a more rational stab at the mid-portion
of the curve, and intends to do just that.
On September 5 the MATIF plans to launch a 5-year French bond futures
contract that has been strongly supported by the French Treasury, which
is an active issuer of mid-curve debt. Options are expected to follow if
the futures contract is successful.
Battle of the Bobl
Competition among European futures exchanges, already intense for post-1999 short-term debt contracts, is shifting up the yield curve. On May 5, MATIF
launched futures and options on medium-term German government bonds (Bobl),
while LIFFE is expected to introduce similar products in September. The
French and British exchanges are gunning for business now dominated by the
Deutsche Terminborse, the all-electronic German futures exchange.
Why would latecomers believe they have a winning chance in a business
where the early bird usually gets, and keeps, essential liquidity? MATIF's
leadership says they aren't really expecting to win much Bobl futures business
from DTB, but instead hope to dominate global Bobl options trading.
"We must launch a future, because that is what the option is based
on, but in fact we expect our Bobl options to be priced of DTB's futures
contract," said Louis-Armand de Rouge, MATIF's President. MATIF, and
many European traders say that DTB's Bobl options business is constrained
because trading options on computer is still inefficient. This technical
anomaly creates an opportunity for open-outcry exchanges.
LIFFE jumped into the fray after the MATIF's Bobl announcement, in part
to protect its lucrative franchise in German government long-bond futures.
LIFFE consistently trades two German Bund futures contracts for every one
traded on DTB. LIFFE leadership believes that if there is a market outside
Germany for Bobl derivatives, then London is the place for them.
Wide Open Pits at the CME
In a little-noticed announcement this Spring, the Chicago Mercantile
Exchange said that it would throw open its trading floor to any new technologies
its members wanted to introduce. The goal, the exchange said, was to "unfetter"
the CME's members and member firms to deploy whatever technological innovation
they believe can enhance open-outcry markets.
All U.S. futures exchanges have restricted the entrepreneurial use of
technology on their floors to some degree, fearing that proprietary equipment
would give one floor trader an advantage over others. The CME was the most
conservative of all. For years, telephone headsets, hand-held broker books
and even computers with charting capabilities were forbidden.
Now, new CME leadership wants the trading floor to become a bazaar. "The CME is in the business of creating a marketplace," said Rick Kilcollin,
CME President. "It is silly for us to be developing technology when
our members are already doing that very well."
Longer Days in the T Bond Pit
If the board of directors of the Chicago Board of Trade gets its way,
Chicago's Treasury Bond futures traders will have to stand in the pit for
an extra hour each afternoon starting on April 2, 1998. The longer futures
session has been proposed to capture more of the U.S. government securities
cash market trading day in New York.
For decades, the cash government securities markets traded on for two
hours after the Chicago pit closed at 2 p.m. Central time. Last year, the
CBOT realized it was missing an opportunity when it turned on its computer
trading system in early afternoon and found it quickly flooded with orders.
The longer pit session was recommended as the exchange voted to shut
down its 10-year-old evening open outcry session in favor of its Project
A computer system.