Recent proposals from the US Securities and Exchange Commission (SEC) to boost risk management in the field of mutual funds may yield unintended consequences, says ratings agency Fitch.
As the SEC announced close the end of last month, a new rule it has developed (titled 22e-4) would require mutual funds – including open-end investment companies, such as exchange-traded funds (ETFs) – to implement liquidity risk-management programmes along a set of unified standards.
If the rule passes into law, the standards would require each relevant fund to observe the following requirements:
Money market funds (MMFs) are excluded from the proposals.
Essentially, under the four measures, each fund would be required to classify – and engage in ongoing examination of – every asset in its portfolio. The classification would be based upon the number of days in which the fund’s position would be convertible to cash, at a price that does not materially affect that asset’s value immediately prior to sale.
Each fund’s board team – including a majority of its independent directors – would be responsible for approving the fund’s liquidity risk-management programme, including the three-day, liquid-asset minimum.
Boards would also be responsible for coordinating written reports that review the adequacy of their programmes, to be provided at least once per year by the fund’s investment adviser – or other, principal officer tasked with administering the steps.
In a further move, the SEC has also proposed amendments to rule 22c-1 of the US Investment Company Act that would permit – but not require – open-end funds, except MMFs or ETFs, to utilise so-called ‘swing pricing’.
As the SEC explained in its statement, swing pricing is the process by which a fund reflects in its net asset value (NAV) the costs associated with shareholders’ trading activity, in order to pass those costs on to the purchasing and redeeming shareholders.
The objective is to protect existing shareholders from any dilution associated with shareholder purchases and redemptions, and is therefore another tool to help funds manage liquidity risks.
Pooled investment vehicles in certain foreign jurisdictions, the SEC pointed out, currently use various forms of swing pricing.
A fund that chooses to use swing pricing would typically reflect in its NAV a specified amount – the ‘swing factor’ – once the level of net purchases into, or net redemptions from, the fund exceeds a set percentage of its NAV; that percentage is known as the ‘swing threshold’.
The SEC’s proposed amendments to the Act include stipulating a range of points that funds would have to consider to determine their swing thresholds and swing factors – and a commitment to annually review their thresholds.
Again, boards – including independent directors – would be required to approve the fund’s swing pricing policies and procedures.
In a special opinion published on 8 October, Fitch said that the liquidity risk management steps “could leave the funds better equipped to handle bouts of market volatility, but there may be unintended consequences”.
It explained: “The proposals could exacerbate the threat of declining market liquidity by increasing fund managers’ aversion to less liquid, fixed-income assets – particularly for smaller issues, and less traded sectors.
“Small issues and sectors, such as emerging markets and high yield – which are already traded less frequently – could see marginally weaker interest from bond mutual funds and ETFs.”
However, it added: “The inclusion of swing pricing in the proposals may be an important offset to any negative side effects on less liquid areas of the bond and loan markets. Swing pricing would permit a fund to be required, under certain circumstances, to effectively allocate the transaction costs of selling assets to the selling shareholder, as opposed to all shareholders.
“Fitch believes that swing pricing could be an effective influence on investors’ behaviour, as it is a disincentive to trading under high-volatility conditions. Its influence could curb potential market dislocations in the first place.”