Plan advisers need to take note of the SEC’s swing-pricing rule
Due diligence considerations that plan advisers should make when a fund has adopted swing pricing.
What investors don’t know about can hurt them. Hidden costs, for example. In a mutual fund, costs can be created by active traders but be borne disproportionately by the buy-and-hold investors in the fund.
A recent rule proposal by the Securities and Exchange Commission includes an interesting provision that allows mutual funds the option to establish a more equitable allocation of trading costs during times of market stress. Funds would be able to adjust (i.e., “swing price”) the net asset value of shares to apply the costs of trading to parties actually engaged in trading.
The SEC’s so-called swing-pricing rule has not attracted much attention, but fiduciary advisers and plan sponsors should keep tabs on this promising regulatory initiative. Swing-pricing policies are more common in Europe. According to a 2011 BlackRock study of some of its own international funds, swing pricing works. It can benefit long-term investors by allocating trading costs to block trades or during financial panics when heavy redemptions occur.
After a heavy day of trading in a fund, non-redeeming investors are left holding the proverbial bag for the hard costs of trading and the price impacts that large trades can have on the securities involved. Shareholders in funds with more illiquid holdings are particularly vulnerable. The 2008 crisis provides a case in point, with funds holding mortgage-backed securities forced into “fire sales.” The holdings of ongoing investors were diluted when they were hit with the double whammy of trading costs and sharply falling NAVs caused by pressure on the funds to quickly unwind illiquid positions. The funds that are currently most likely to experience problems during periods of market turmoil, according to the SEC, are alternative strategy, fixed-income and emerging market funds.
BlackRock, which already has instituted swing pricing in some of its international funds, found that buy-and-hold investors in some funds received a performance benefit ranging from 38 basis points to 2.52% over a 12-month period between 2010 and 2011.
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According to the SEC’s proposal, funds adopting swing pricing would have to disclose to investors the factors they use in establishing a trigger – called a “swing threshold” — for adjusting the NAV for significant trading activity. Under a fund’s swing policy – which would define the particular conditions triggering swing pricing — investors selling shares could receive less than the fund’s stated closing price. The SEC’s swing-policy rule would not apply to ETFs or money market funds.
The swing-policy provision is part of a broader effort by the SEC to address the threat of liquidity risk. The bulk of the proposal mandates minimum liquidity levels and new risk disclosures. As such, the rule would require fund managers to classify holdings in one of six categories based on liquidity and also maintain a three-day minimum liquidity reserve, or cash-equivalent reserves, to be able to make redemptions without significantly affecting NAV. Although investors are accustomed to redeeming shares immediately, by law mutual funds can suspend redemptions for up to seven days.
An SEC economic analysis noted that several large European-based mutual funds suspended redemptions during the financial crisis, while U.S. mutual funds saw large outflows. The SEC study indicates that cash holdings in mutual funds continue to vary widely. In 2014, the median fund held 1.8% of its portfolio in cash, but a quarter of funds held 0.2% or less, and the top quartile held 4.4% or more.
The swing-pricing and liquidity management rule represents the second of five initiatives that SEC chairwoman Mary Jo White announced a year ago. The Financial Stability Oversight Council, which was set up by the Dodd-Frank Act to assess market risk, had been pressuring the SEC to take action. The commission already has adopted a rule for money market funds and this past May proposed greater disclosure of the use of derivatives in funds and advisers’ client portfolios. Other pending rules include the use of derivatives in funds, advisers’ transition plans during emergencies and stress tests for large asset managers.
Although not many comments have been received on the proposal, which has a January 13, 2016 deadline, several groups have met with SEC staff, including the mutual fund section of the American Bar Association, BlackRock and the Luxembourg trade association of mutual funds. The U.S.-based Investment Company Institute has not yet taken a position.
Investment advisers and plan sponsors should consider the impact of swing pricing on their fiduciary duty of care. In practical terms, swing pricing should be part of their mutual fund due diligence process. If a fund has adopted swing pricing, advisers should consider, among other things, the factors used by the fund in determining the swing threshold, whether the fund has significant illiquid holdings and the client’s time horizon and investment strategy.
Blaine F. Aikin is chief executive of fi360 Inc.
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