The SEC’s new liquidity proposal would allow open-end funds (other than ETFs and money-market funds) to voluntarily implement “swing pricing,” “a process of adjusting the net asset value of a fund’s shares to pass on to purchasing or redeeming shareholders more of the costs associated with their trading activity.” The SEC sees the mechanism as “an additional tool to mitigate potential dilution and to manage fund liquidity.” The proposal suggests that swing pricing may be preferable to redemption fees for minimizing dilution caused by shareholder transactions in fund shares because it doesn’t require coordination with the fund’s service providers and therefore can avoid the operational complexity that may accompany redemption fees.
The decision to implement swing pricing is voluntary and does not have to be consistent across the entire fund complex; therefore, swing pricing could be used only for some funds across the complex and different swing thresholds can be established for different funds. However, once the fund has the program in place, there is no discretion in whether swing pricing in applied absent board approval of a change to the fund’s policies.
To implement swing pricing, a fund’s board, including a majority of the independent trustees, would be required to approve relevant policies and procedures. A fund’s board would also be responsible for approving any material changes to the policies and procedures, and the release includes changes to the swing threshold, changes to the upper limit of the swing factor, and any suspension or termination of the procedures within that category.
The board would be required to designate the fund’s adviser or officers responsible for administering the policies and procedures. The release suggests “that a fund’s board may wish to consider requiring the fund’s swing pricing policies and procedures to be administered by a committee, and to specify the officers or functional areas that comprise the committee (taking into account any possible conflicts for the fund and the adviser related to swing pricing).”
The framework is designed to preserve the board’s oversight role without having to become involved in what may be necessary on a day-to-day basis to administer such a program. According to the release, board oversight “would help ensure that a fund establishes and implements swing pricing policies and procedures that are in the best interests of all the fund’s shareholders” and reflects the board’s historical “significant responsibility regarding valuation- and pricing-related matters.” By allowing the designation of an individual (or individuals) to administer the program, the SEC recognizes that it is not
Swing Threshold
The policies and procedures must set the “swing threshold,” defined as “the amount of net purchases into or net redemptions from a fund, expressed as a percentage of the fund’s net asset value, that triggers the initiation of swing pricing.” In-kind purchases and redemptions are excluded from this calculation because the SEC believes that these transactions do not present the same risk of dilution as cash transactions. To set the threshold, the fund would need to consider:
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The size, frequency, and volatility of historical net purchases or net redemptions of fund shares during normal and stressed periods;
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The fund’s investment strategy and the liquidity of the fund’s portfolio assets;
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The fund’s holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources; and
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The costs associated with transactions in the markets in which the fund invests.
The release notes that considering these factors will assist the fund in setting the threshold at a point that will “generally reflect the estimated point at which net purchases or net redemptions would trigger the fund’s investment adviser to trade portfolio assets in the near term, to a degree or of a type that may generate material liquidity or transaction costs for the fund.” The fund’s procedures must include a review of the swing threshold at least annually and the release suggests that the fund may want to review the policies more often. Additionally, the policies and procedures may contemplate “any circumstances that would prompt ad-hoc review of the fund’s swing threshold.”
The proposal acknowledges that the deadline for striking the NAV may occur before the fund has final information regarding flows and other information, and thus would permit the individuals responsible for administering the program to make the swing pricing determination based on “information obtained after reasonable inquiry.”
Swing Factor
Once the swing threshold is crossed, a fund would adjust its NAV by a “swing factor,” defined as “the amount, expressed as a percentage of the fund’s net asset value and determined pursuant to the fund’s swing pricing procedures, by which a fund adjusts its net asset value per share when the level of net purchases or net redemptions from the fund has exceeded the fund’s swing threshold.” In other words, if net redemptions exceeded the fund’s defined swing threshold, the fund’s NAV would be adjusted downward by the fund’s swing factor for all investors transacting that day, thus reducing the proceeds received by redeeming investors in order to cover increased transaction and market costs. For days in which net purchases exceeded the swing threshold, the NAV would be adjusted upward by the swing factor.
A fund’s swing pricing policies and procedures would be required to include policies and procedures for how the swing factor will be determined. However, the release acknowledges that the swing factor will vary. Therefore, rather than specify the factor, the fund’s policies and procedures “generally should detail how each of the factors a fund would be required to consider under the proposed rule would assist the fund in calculating the swing factor.” In setting the swing factor, the fund would need to evaluate:
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any near-term costs that are expected to be incurred as a result of net purchases or net redemptions that occur on the day the swing factor is used to adjust the fund’s NAV, including any market impact costs, spread costs, and transaction fees and charges arising from asset purchases or asset sales in connection with those purchases or redemptions, as well as any borrowing-related costs associated with satisfying those redemptions; and
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information about the value of assets purchased or sold by the fund to satisfy net purchases or net redemptions that occur on the day the swing factor is used to adjust the fund’s NAV (if that information would not be reflected in the current NAV of the fund computed on that day).
To avoid conflicts, the rule “would require the determination of the swing factor to be reasonably segregated from the portfolio management function of the fund.” The SEC expressed concern that a portfolio manager, for example, may have an incentive to set the swing factor artificially low to avoid short-term lagging performance compared to peers or a fund’s benchmark.
The proposal also acknowledges that the board should not be involved in approving each swing factor. The release acknowledges the operational difficulties of requiring board involvement in this area as well as the fact that such a determination “would not be consistent with boards’ historical oversight role.”
The proposal does not place an upper limit on the swing factor due to “the difficulty of establishing an appropriate across-the-board limit that would permit funds with different investment strategies, under all market conditions, to determine a swing factor that reflects the costs associated with the potential shareholder purchase or redemption activity.” However, a fund would be permitted to include an upper limit in its policies and procedures. Such a limit, as well as any changes, would have to be approved by the fund’s board.