Generic Guidance on 'Generic' Derivatives Disclosure—Recent Comments From the Staff on Derivatives Disclosure: Part 2


Part II — Shareholder Reports

Able, Baker and Charlie are three bond fund portfolio managers. Each believes that a substantial increase in interest rates is imminent and decides to sharply reduce the portfolio's duration in order to reduce the impact of a rate increase. Able's fund is not set up to execute derivative contracts, so she reduces the fund's duration by selling longer-dated bonds and reinvesting in short-term obligations. Baker has her fund sell CME Futures on the Two-Year Treasury Note to reduce her fund's duration. Charlie reduces his fund's duration by entering into a standard interest rate swap in which the fund will receive three-month US$ LIBOR and pay a fixed rate. All three funds' durations are reduced by exactly the same amount as a result of these trades.

The portfolio managers make the right call—interest rates rise and their funds' net asset values fall much less than their benchmark index and peers'. In fact, a performance attribution system ascribes 80 percent of the funds' outperformance of the benchmark to their shortened durations. At the end of the fiscal year in which this occurs, each portfolio manager writes the mandatory discussion of his or her fund's performance (known as the Management Discussion of Fund Performance, or MDFP), which includes the following paragraph...

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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