Swing pricing requires changes to '40 Act regime – asset managers

US mutual fund processes need upgrading for SEC proposals to be viable, say asset managers

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BlackRock has welcomed proposals from the US Securities and Exchange Commission (SEC) that open-ended fund investors should be free to adopt swing pricing – but urges the commission to rewrite mutual fund rules to make the change workable.

BlackRock says the 1940 Act fund regime would need adjusting for asset managers to introduce swing pricing, a mechanism that is allowed in several European jurisdictions but has been prohibited in the US.

A move to swing pricing, whereby investors take losses when redeeming their investment if markets are illiquid, would mean upgrading technology and data collection processes, the asset manager says.

In its feedback to the SEC's proposals, published on January 13, BlackRock argues that passing on higher bid-offer spreads and other associated liquidity costs to redeeming investors would deter investors from pulling out of the fund in a liquidity crisis and boost returns for long-term investors.

"The long-term total return impact of compensating long-term fund shareholders for the transactions and market impact costs incurred by more transient investors can be quite significant," write BlackRock's vice-chairwoman Barbara Novick and managing director Benjamin Archibald. "A price signal to redeeming – or subscribing – investors will also have a counter-cyclical impact on investor behaviour over time, which will tend to reduce the risk of generalised runs on a particular type of asset class."

BlackRock, which manages funds in several European jurisdictions that allow swing pricing, has consistently supported introducing the measure in the US.

The proposal is part of a package of liquidity measures on open-ended funds, including mutual funds and exchange-traded funds (ETFs), announced by the SEC in a bid to address concerns about systemic risk in the asset management industry.

Nonetheless, BlackRock argues the SEC must do more to facilitate swing pricing. "To become a practical reality for 1940 Act funds, the commission must recognise that... the operational infrastructure required to practically enable swing pricing does not readily exist for the vast majority of US mutual funds," Novick and Archibald say.

Measuring flows

The main problem is measuring net fund flows. In the US measuring fund flows and net asset value (NAV) happens simultaneously as two separate processes. In Europe investors are given a cut-off to subscribe to or redeem from a fund, which typically occurs several hours before the NAV is calculated.

George Gatch, chief executive of global funds management at JP Morgan Asset Management, says: "We are not confident in our ability to determine a fund's net flows in a timely fashion and with sufficient certainty to warrant adjusting the NAV [by the next day].

"In the US we are required [by SEC prospectus guidelines] to accept shareholder orders until the fund is closed for valuation at 4pm. NAVs must be submitted for publication by 6pm. Meanwhile trade flows for funds that are sold via third-party distributors are generally not available until the early morning of the next day.

"By contrast, in Luxembourg, we stop accepting orders at 2:30pm Central European Time and receive cash projections at 5:30pm. NAVs are released at 7:15pm."

The Global Association of Risk Professionals (Garp) convened a panel of 10 large investors to consider how best to change the US mutual fund infrastructure to facilitate swing pricing. Sitting on the panel were AB, BlackRock, Deutsche Asset Management, Goldman Sachs Asset Management, JP Morgan Asset Management, MFS Investment Management, Neuberger Berman, Nuveen Fund Advisors, Oppenheimer Funds and Western Asset Management.

In its response to the SEC proposals, Garp says moving the cut-off time for redeeming investors would be insufficient and that radical changes to the reporting and data collection infrastructure are needed. Under Garp's suggestions, a series of new deadlines would speed up service providers to provide fund flow data, funds would be allowed to rely on estimated NAVs and it would be legitimate for prior-day NAVs to be adjusted.

BlackRock advises the SEC that the costs of upgrading technology ought to be borne by investors, and adds that the benefits to the stability of the financial system should outweigh the costs.

US investors responding to the SEC's proposals are less keen on other measures, such as the requirement to classify the liquidity of portfolio assets and comply with industry-wide liquidity caps and floors. Under such rules, asset managers would be asked to hold a minimum threshold of assets that can be converted into cash in three business days, and assets that may not be sold in seven days would be capped at 15% of their portfolios. The minimum benchmark for liquid assets would differ for each fund, depending on their cash flows and access to funding.

Some respondents disagree with the suggestion that asset managers should have discretion in how to classify assets. "The regulator and the industry will have no consistency across funds – how will investors evaluate liquidity across different funds if they can't compare?" asks one US investment manager, adding that more conservative asset managers could be penalised for having higher illiquidity estimates. He says he would prefer regulators to define more precisely what assets would go into which liquidity bucket.

Multi-tier assets

JP Morgan Asset Management and BlackRock take issue with the use of a "days to liquidate" metric as highly subjective, saying funds would end up employing differing methodologies. BlackRock suggests the SEC classifies portfolio holdings based on the type of asset, proposing five categories of liquidity based on asset class and credit quality.

Tier 1, for example, would include easily liquidated assets such as listed developed-market and emerging-market equities, futures, interest rate swaps, forex and above-A-rated government bonds. Tier 2 would contain B- to BBB-rated government bonds, investment-grade corporate debt and frontier-market equity. Tier 5 would contain assets such as unlisted equities and defaulted securities.

"We recommend removing the three-day liquid asset minimum from the proposal and replacing it with a requirement that funds take several steps to ensure an appropriate level of Tier 1 and Tier 2 assets is maintained," say BlackRock's Novick and Archibald.

Such an approach avoids a "days to liquidate" methodology, which would be based on position size and price. In its response to the SEC, Vanguard also criticises the commission for equating fund size with an increased liquidity risk, and defining liquidity based on asset prices rather than the ability to redeem investors in cash.

Mortimer Buckley, chief investment officer at Vanguard, says that the SEC's planned framework "suffers from a bias against large funds", which he argues are usually less volatile than small funds.

"The six-bucket liquidity classification framework is flawed because it… does not provide meaningful tools for the commission and could mislead investors by implying a degree of precision in liquidity classifications that does not exist," he concludes.

Some respondents question the premise of the SEC's liquidity measures. Marie Knowles, chair of the independent trustees for Fidelity Fixed Income and Asset Allocation Funds, says: "Studies produced by both academics and policy think-tanks provide overwhelming evidence that, even in periods of deep market distress, net flows from open-end mutual funds have not previously posed liquidity challenges."

Others suggest it would be simpler were the SEC instead to introduce gates, side-pockets and early redemption fees, traditionally used by hedge funds to deter an investor sell-off.

Andrew Chin, chief risk officer at AB in New York, worries the SEC could make matters worse by forcing asset managers to declare liquidity levels, which in turn would herd them towards investing in the same assets.

"The SEC proposal as it stands today would create more crowding behaviour. There would be a danger of becoming more homogenous because we would have to disclose this information about liquidity to customers and might fear being different from our competitors. We could end up a lot more concentrated in what we believe to be more liquid assets," he says.

BlackRock advises the SEC against prohibiting the purchase of less liquid assets when a fund has fallen below a mandated minimum level. This "could encourage more redemptions, as remaining investors may believe the fund will no longer be able to effectively employ its investment strategy", the asset manager says.

JP Morgan Asset Management echoes BlackRock in recommending a less subjective asset-type categorisation, rather than one based on days to liquidate, as a more objective approach could be more easily based on inputs from third-party data providers.

"We expect that over time, funds' approach to liquidity classification will look similar to valuation procedures, whereby we receive a data feed with a variety of quantitative information from third-party service providers, which we review and test – daily and retrospectively – and scrutinise any position that triggers a flag," says JP Morgan's Gatch.

"Without such an automated approach to narrow down the securities that require individual attention, it would be challenging to assess liquidity at a position level on an ongoing basis."

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