To address mutual funds’ liquidity management under stressed conditions, the U.S. Securities and Exchange Commission proposed a package of regulatory amendments titled “Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT.”
That was in November 2022. On August 28 this year came the announcement of the final rule, “Form N-PORT and Form N-CEN Reporting; Guidance on Open-End Fund Liquidity Risk.”
There was “guidance,” to be sure, but swing pricing per se was conspicuously absent. The commission officially said little more than that “we are not adopting amendments to the underlying rules at this time” pertaining to swing pricing and liquidity classifications.
The reporting requirements that were adopted, including timely Form N-PORT information on portfolio holdings, “will benefit investors through greater transparency of funds’ investment portfolios and improve the commission’s oversight of the asset management industry,” said SEC Chair Gary Gensler.
The inaction on mandatory swing pricing – defining when net asset values (NAVs) would be adjusted due to unexpected or extreme inflows or outflows – caught many by surprise.
Tess Virmani, deputy general counsel and head of policy at the Loan Syndications & Trading Association (LSTA), deemed it “unexpected” that the SEC would adopt parts of the 2022 proposal, when it has indicated that re-proposed “changes to regulatory requirements relating to open-end funds’ liquidity and dilution management” are under consideration for next April.
The 2022 proposal was prompted primarily by sizable outflows from open-end funds at the time of the 2020 pandemic outbreak. In a variation on “front running,” share values of investors who did not redeem quickly were diluted. The SEC indicated, however, that it did not have specific data on the dilution. The agency noted in its proposal that swing pricing increased among European open-end funds under similar market conditions, and that fund managers with operations in the U.S. and Europe said swing pricing would have been helpful.
Tess Virmani, LSTA
K&L Gates partner Jon-Luc Dupuy criticized the comparison with Europe, because swing pricing is voluntary there and intermediary structures between funds and investors differ from how the U.S. fund industry operates.
Virmani said historical data is lacking on dilution risk, and market participants questioned whether the SEC’s proposed rule was warranted.
Open-end fund redemptions overall, and in fixed income particularly, skyrocketed in March 2020, but stability returned within a few months. The sector benefited from emergency Federal Reserve interventions.
“I was struck in reading the proposal that the event was being used to justify these really drastic changes,” Virmani said. She maintained that a 2016 rule in force (Rule 22e-4: Investment Company Liquidity Risk Management Programs) “clearly worked, and the mutual fund industry came through the pandemic intact.”
The Investment Company Institute had pointed out that swing pricing was “optional for use as appropriate, at the discretion of the investment manager,” while an SEC mandate would have allowed no discretion.
“This would impose unnecessary and significant costs with little evidence of the need for such a sweeping transformation,” says an ICI web page. “While swing pricing can be a useful tool under certain circumstances, the SEC’s proposal is a one-size-fits-all approach that doesn’t consider a fund’s structure and objectives.”
Jon-Luc Dupuy, K&L Gates
Another concern, cited by Dupuy, was a hard close requirement that all orders received by funds and their transfer agents arrive by 4:00 pm. Intermediaries such as 401(k) and pension plans would likely require earlier cut-offs, giving investors capable of submitting orders closer to 4:00 the benefit of a longer trading window.
“A swing factor discount or premium, coupled with a hard close and earlier cut-off times, could result in a form of arbitrage that never existed before with mutual funds,” Dupuy said. That could disadvantage Main Street investors and “put the industry at considerable risk.”
The recently adopted guidance on fund liquidity risk management suggests that the SEC may regard the 2016 rule, which aims to prepare firms for significant fund sales or purchases, as the best solution for now. Among what is included, the guidance reiterated, is the assessment, management and periodic review of a fund’s liquidity risk; classifying and reviewing at least monthly how fund assets fit within four categories, ranging from liquid to illiquid; determining and periodically reviewing a highly liquid investment minimum for certain funds; and limiting illiquid investments.
“It’s no different from the world before the guidance, but the SEC must have decided it was important to point it out again, based on their conversations with fund managers,” Virmani said.
Should the SEC decide additional measures are required, Dupuy said, it could propose alternatives to swing pricing that fund managers and investors see as less problematic, for example, liquidity fees when redemptions exceed a certain amount, similar to what applies to certain institutional money funds.
Although the industry would likely prefer a voluntary approach, the SEC may still choose an option with a mandatory component, Dupuy said.
Under the ongoing guidance, he added, funds cannot maintain more than 15% of their portfolios in illiquid investments, and their classifications must be reviewed intra-monthly when market conditions warrant. The upshot is that in examinations, the SEC “will be looking for whether funds classified or reclassified assets based on market changes.”