Funds with illiquid holdings or hard-to-value assets can expect to face scrutiny from SEC examiners this year, as should ETF providers whose products track custom-built indexes, according to the regulator's list of national exam priorities released Wednesday.

Disclosures of potential conflicts of interest between product providers and end investors is another area the agency emphasized it would be checking.

Unlike last year's list, the Office of Compliance Inspections and Examinations dedicated an entire section to its anticipated review of mutual funds and ETFs. In it, OCIE staffers indicate they will examine funds that have poor performance and liquidity as compared to members of their peer groups, as well as funds with securities that are "difficult to value," particularly in times of market stress.

"I think it's fair to say that mutual funds have made a return to the list," says Nathan Greene, a partner in the Investment Funds practice at Shearman & Sterling.

By homing in on liquidity and performance, the SEC will be watching "what [fund providers are] telling investors when investors buy in about how it's going to perform, and how it's performing consistent with expectations," says Daniel Nathan, a partner at Orrick.

The OCIE also singles out ETFs, and says it will pay closer attention to funds that have "little secondary market trading volume."

"The concern is that if you had an ETF that was troubled and had to be liquidated, remaining investors bear the cost of that liquidation," says Jeremiah Williams, counsel at Ropes & Gray.

The OCIE's alarm may be overblown, however, since an ETF may not trade often but could be widely held and at no risk of being delisted, Orrick's Nathan notes. What's more, liquidating assets does not necessarily cause the value of a fund's holdings to decline, he says.

"I think they're identifying risks and imagining worst-case scenarios," he says.

The OCIE's attention to liquidity comes as firms industrywide prepare to comply with the agency's massive new liquidity risk management rule. The compliance date for complexes with $1 billion or more under management is Dec. 1.

Funds' efforts to prepare for that rule may also help them fine-tune practices ahead of exam-team visits, Shearman & Sterling's Greene says.

"The industry is thinking a lot about illiquid assets," he says. "[A]nd if you're an ETF manager, you're already monitoring your trading volume and spreads in the price on the exchange on a pretty regular basis."

Still, since the OCIE has signaled that it will look more closely at liquidity risk management, firms should consider reassessing how they monitor illiquid assets in their funds, he says.

"If I were inside an ETF firm, I'd want a refresh on that topic," Greene says.

Fund portfolios that include holdings in commercial loans and securitized products should also take another look at whether their valuation practices are sound, Williams says.

"The SEC has been focused on valuation for a number of years now, but here they're specifically calling out registered funds and ETFs," he says.

The SEC has also flagged ETFs that track custom-built indexes, particularly cases in which the ETF provider has sway "with respect to the selection and weighting of index components," the priorities note. Such instances could present conflicts of interest, the regulator notes.

That comes as a growing number of ETF providers ditch well-known third-party providers to build indexes on their own amid a boom in so-called smart-beta strategies, which follow indexes with "tilts" meant to emphasize specific investment factors. Last fall, S&P Dow Jones Indices, a major index provider in its own right, raised the specter that such practices could unleash another Libor-like scandal.

Given the amount of detail the OCIE provided in describing its concerns in these areas, mutual funds and ETFs should carefully review their relevant policies and procedures in order to prevent exams from becoming enforcement actions, says Greg DiMeglio, chair of securities enforcement at Stradley Ronon.

"If you have a business model where your advisory services cross over with these priorities, I would definitely get ahead of the next exam and focus very specifically on the independently articulated priorities," DiMeglio says.

Roughly 70% of exams nationwide result in deficiency letters, and about 10% are referred to the enforcement division, OCIE director Peter Driscoll said in a speech last year.

SEC examiners also plan to focus on potential conflicts of interest in sales practices and fees.

"[T]he proper disclosure and calculation of fees, expenses and other charges investors pay is critically important," the priorities noted.

When reviewing fees, OCIE staffers will be on the hunt for advisors who place clients in funds with higher sales loads or distribution fees without disclosing the conflict of interest, revenue-sharing arrangements that may incentivize advisors to recommend one type of product over another and advisors that move clients from commission-based accounts to fee-based ones, which may actually end up costing clients more.

"It's not new, but it's important to be diligent about looking at your fees, and if there is a potential conflict, making sure those are disclosed and disclosed well," Ropes & Gray's Williams says.

The focus on fees also comes as the agency continues to work on its Standards of Conduct rule for advisors serving retail and retirement accounts, which is broadly seen as a potential replacement to the Department of Labor's now-delayed fiduciary rule.

Cyber security will also remain a focus "in each of our examination programs," according to the priority list.

One notable change from last year's exam priorities is the removal of any reference to money market reform, a top 2017 exam initiative. Since money market fund reform is sometimes framed part and parcel with systemic risk, that oversight might show that "systemic risk regulation, at least in the asset management sector, is moving down the agenda," Greene says.

By and large, the exam priorities shouldn't raise any red flags for fund firms, Orrick's Nathan says.

"I'm not sure this provides any particular fine-tuning for a well-run fund," he says.

SEC to Target Fund Liquidity, Custom Indexes in 2018 Exams

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