As a finance and investment expert, I often encounter questions about Non-Mainstream Investment Securities (NMIS) and their role in mutual funds. Many investors wonder how NMIS mutual funds work, what regulations govern them, and whether they fit into a diversified portfolio. In this article, I will break down the concept of allowed NMIS mutual funds, their risks, benefits, and regulatory framework.
Table of Contents
What Are NMIS Mutual Funds?
Non-Mainstream Investment Securities (NMIS) refer to financial instruments that are not commonly traded on major exchanges. These may include:
- Private equity
- Hedge fund interests
- Structured products
- Certain derivatives
- Unlisted securities
A mutual fund that holds NMIS is subject to stricter regulatory scrutiny because these assets often carry higher risks, lower liquidity, and complex valuation methods.
Regulatory Framework in the U.S.
The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) impose strict rules on mutual funds investing in NMIS. Key regulations include:
- Diversification Requirements – Under the Investment Company Act of 1940, mutual funds must limit NMIS exposure to prevent excessive risk.
- Liquidity Rules – The SEC’s Liquidity Risk Management Program (Rule 22e-4) mandates that funds maintain sufficient liquid assets.
- Valuation Standards – NMIS must be fair-valued under ASC 820 (Fair Value Measurement).
Why Do Mutual Funds Invest in NMIS?
Despite the risks, some mutual funds include NMIS for:
- Higher potential returns – Some alternative assets outperform traditional stocks and bonds.
- Portfolio diversification – NMIS may have low correlation with mainstream markets.
- Inflation hedging – Certain NMIS, like commodities, protect against inflation.
Example: A Hedge Fund-Embedded Mutual Fund
Suppose a mutual fund allocates 10% to a hedge fund strategy. The expected return of the hedge fund is E(R_h) = 12\%, while the rest of the portfolio (90%) tracks the S&P 500 with E(R_s) = 8\%. The total expected return would be:
E(R_p) = 0.10 \times 12\% + 0.90 \times 8\% = 8.4\%This shows how NMIS can enhance returns, but it also introduces volatility.
Risks of NMIS Mutual Funds
| Risk Factor | Description |
|---|---|
| Liquidity Risk | NMIS may be hard to sell quickly without price discounts. |
| Valuation Risk | Illiquid assets rely on models rather than market prices. |
| Regulatory Risk | Changing laws may restrict NMIS holdings. |
| Counterparty Risk | Derivatives and structured products depend on third-party solvency. |
Case Study: The 2008 Financial Crisis
Many mutual funds holding mortgage-backed securities (MBS)—a type of NMIS—faced massive losses when liquidity dried up. The lesson? Excessive NMIS exposure can amplify downturns.
How to Evaluate an NMIS Mutual Fund
Before investing, ask:
- What percentage of the fund is in NMIS? (SEC filings disclose this.)
- How does the fund value illiquid assets? (Look for independent pricing.)
- What are the historical drawdowns? (Check stress-test results.)
Performance Comparison: NMIS vs. Traditional Mutual Funds
| Metric | NMIS Mutual Fund | Traditional Mutual Fund |
|---|---|---|
| Avg. Return | 9.5% | 7.2% |
| Volatility | 18% | 12% |
| Liquidity | Low | High |
This table shows that while NMIS funds may offer higher returns, they come with greater volatility and lower liquidity.
Tax Implications
NMIS mutual funds may generate:
- Unrelated Business Taxable Income (UBTI) – If the fund invests in private partnerships.
- Complex capital gains – Due to frequent rebalancing of illiquid assets.
Consult a tax advisor before investing.
Final Thoughts
NMIS mutual funds can be a valuable but risky addition to a portfolio. They suit sophisticated investors who understand illiquidity and valuation challenges. Always review the prospectus, assess fee structures, and consider consulting a financial advisor.
Would I personally invest in them? Only if I had a long-term horizon and a high-risk tolerance. For most investors, a small allocation (5-10%) may provide diversification without excessive exposure.
