Mutual fund liquidity has been a hot topic in policy circles for the last few years. On 10 December 2015, the market got a glimpse of why, when Third Avenue Asset Management announced it was suspending trading and liquidating its Focused Credit Fund due to unsustainable redemption requests. It was the biggest US mutual fund failure since the Reserve Primary Fund broke the buck.
To many, Third Avenue’s liquidation proved that the US Financial Stability Oversight Council (FSOC) and the Financial Stability Board (FSB) were correct to worry about potential liquidity issues with mutual funds. In recent years, both the FSOC and FSB have been investigating what policy tools could be put in place to mitigate liquidity risks with mutual funds and, ultimately, avoid events such as the Third Avenue liquidation.
A few months before the Third Ave affair, the US Securities and Exchange Commission (SEC) had already begun creating new liquidity rules for US mutual funds. These rules were almost certainly in response to the questions raised by the FSOC.
In September 2015, the SEC released its proposed Open-End Fund Liquidity Risk Management Programs and Swing Pricing rules. These rules would require all registered open-end funds, including exchange-traded funds, to adopt detailed liquidity risk management programs, as well as associated governance practices and disclosures. In addition, open-end funds would be able to employ “swing pricing.” The rules are designed to ensure the redeemability of open-end fund shares and to reduce or eliminate the dilution of remaining shareholder interests following redemption activity.
The proposal suggests numerous potential changes to various rules, forms, and regulations. Some of the most notable changes include requirements to:
- Maintain a classification of portfolio securities into six liquidity categories, based upon how quickly the securities could be converted to cash.
- Calculate and maintain a capital-requirement-like buffer known as the fund’s “three day liquid asset minimum”.
- Have the board of mutual funds directly approve, oversee, and periodically review their fund’s liquidity risk management practices.
- Provide enhanced disclosure in both new and existing reporting (such as Form N-1A and new Forms N-PORT and N-CEN).
It is important to note that the liquidity risk management and swing pricing proposal is part of a series of installments in a plan to overhaul the regulation of US mutual funds. These installments are interrelated and often feed each other. On 11 December 2015, the SEC released a new proposed rule regarding derivatives, and disclosure modernization rules are already under consideration. SEC Chair Mary Jo White has indicated that her agency will also look at how asset managers plan for transition of key personnel and implement appropriate stress tests for funds and advisors. Any one of these proposals presents technological, data management, workflow, and governance challenges for asset managers. Taken together, they represent a huge challenge for US asset management.
The liquidity proposals were a hot-button issue before the Third Ave affair and have only taken on more urgency since. In 2016, to gear up for compliance requirements that will likely follow in 2017 or 2018, asset managers must ensure they can analyze, classify, and communicate fund holdings and liquidity.
Currently, the industry is struggling to comprehend the enormity of the task before them and, specifically, where and how to respond during the comment period. Many do not take issue with the notion that funds should be required by rule to establish a liquidity risk management program, but balk at the SEC’s one-size-fits-all approach. While the SEC is certainly attentive to industry concerns, the impetus that put these proposals into play cannot be wished away. Asset managers must lay the groundwork now to meet future compliance deadlines.
An important part of the SEC’s liquidity proposal attempts to mitigate the dilutive trading impact of “fire sale” assets during a period of fund outflows, as well as higher purchase costs during fund inflows. In effect, the proposal seeks to curb what is known as “first mover advantage”, in which larger, nimble institutions may have an advantage over retail investors.
Under the terms of the proposal, swing pricing would be a partial swing, with a threshold that would be decided upon by a board; swing employed when inflows or outflows exceeded a certain percentage of total net assets and triggered an associated increase or decrease in net asset value (NAV), otherwise known as the swing factor.
As with other aspects of the liquidity management rules, swing pricing poses a significant governance and operational challenge for asset managers. They must be able to analyze relevant data, document their choice of swing factor and threshold, and present all relevant information to boards, marketing departments, clients, counsel, and regulators. There is a clear relationship between the complexity of investment strategy and frequency of swing policy maintenance, especially for those strategies that employ a more dynamic asset allocation in response to market events.
Aside from the governance and operational considerations, the underlying challenge of swing pricing, as with liquidity management, is one of access to and insight into relevant and timely data. In order to be most effective, shareholder flow data must be available quickly, even for large orders or sales, and those that come late in the day. After all, managers are only as good as their largest or latest orders. Therefore, the pressure will be on for transfer agents and distributors, who will need to collect and send data as rapidly as possible so that clients have a full picture of share flows on a particular date.
Another important consideration for portfolio managers will be how swing pricing may affect performance measures, since these are relied on by investment consultants and fiduciaries, who need to show stakeholders the potential effects of a swing.
For fund families that already have European funds, implementing and using a swing pricing system may be easier, since it is already prevalent within the UCITS landscape. For investment managers new to the practice, however, it will undoubtedly bring pressure to bear on boards and operational units.
This article was originally published in the 2016 Regulatory Field Guide. The guide features insights from a number of our experts on key regulatory developments that will have the greatest impact for asset managers in the year ahead – and beyond. Visit bbh.com/regulatoryfieldguide to explore the guide.