SEC liquidity rules could punish larger funds

Risk USA: funds that have grown too big for their strategies could be exposed

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The biggest US mutual funds may be adversely impacted by the Securities and Exchange Commission's (SEC) new liquidity risk management rules, asset managers have warned.

"Certainly, fund size is an important [factor] and larger funds would be disadvantaged," said Tilak Lal, chief risk officer at K2 Advisors, a subsidiary of Franklin Templeton, adding: "And I would say they should be."

Lal was speaking on a panel at the Risk USA conference in New York earlier today (November 10).

SEC rule 22-e4, which was adopted last week, requires open-ended mutual funds to classify their holdings in a series of ‘liquidity buckets' based on the length of time it would take to convert them to cash in current market conditions.

When assessing portfolio liquidity, asset managers must first define a ‘reasonable' trade size for each security. Since larger funds need to trade in bigger size, they may be forced to put more of their holdings in less liquid buckets than a smaller fund with similar investments.

Fund managers have considerable discretion to define what amounts to a ‘reasonable' trade size. However, if a fund is seen as an outlier in its definitions, it will raise questions about whether its strategy is suitable for an open-ended mutual fund.

"Clearly, one of the things the SEC is asking every mutual fund adviser to do is ask the question, is this strategy appropriate for an open-end mutual fund? The answer may be no, if the liquidity doesn't match their expectations," said Alec Crawford, chief risk officer at New Jersey-based asset manager Lord Abbett.

K2's Lal said rule 22-e4 could allow the SEC to identify funds that are becoming too big for their investment strategies. "From an investor's perspective, there's the issue of capacity. Is this fund too big for its underlying assets? And the idea is this, some funds shouldn't be as big because of the underlying assets they have," he said.

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