The last time the SEC issued guidance regarding fund liquidity, other than for money market funds, was over 20 years ago. However, in September that stretch was broken when the SEC unanimously approved a proposal geared towards providing stronger liquidity risk management for mutual funds and exchange-traded funds (ETFs). The SEC’s goal is to reduce the risk that funds will be unable to meet redemption obligations and to mitigate potential dilution of the interest of fund shareholders.
The proposal focuses on three primary areas:
- Establishing a liquidity risk management program tailored to the fund’s own liquidity risk,
- Permitting the use of swing pricing (excluding ETFs), and
- Enhancing disclosure and reporting requirements.
However, the proposal also presents a few potential issues that fund managers should be aware of.
Under the proposal, funds would be required to classify, manage and continually review the liquidity of their assets. In addition, funds would need to assess and review their own liquidity risk as it relates to their ability to meet redemptions under normal and reasonable foreseeable stress conditions. While one would hope that funds already have procedures in place to monitor their liquidity risk, the proposal includes certain factors funds must consider. The additional factors could potentially increase operational costs that may be ultimately passed down to shareholders.
The proposal also does not specify the frequency with which funds should assess its liquidity risk but, rather, allows funds to adopt individualized, tailored procedures. This fund-specific customization could increase the liability borne by boards, opening the door for a potential SEC-enforcement action if the agency determines a board does not review and approve procedures frequently enough.
Funds also would be required to determine and reasonably maintain a minimum portion of assets that they believe are convertible to cash within three business days, at a price that does not materially affect the value of that asset immediately prior to sale. This requirement may force certain portfolio managers to fundamentally reassess or alter their strategy, because the SEC suggests the minimum should reflect the uncertainty associated with a fund’s accuracy in projecting net redemptions during changing market conditions.
One method the SEC is proposing as an option to help manage liquidity risk for mutual funds (excluding ETFs) is swing pricing. Swing pricing is the process of adjusting the net asset value (NAV) to effectively pass on the cost from shareholder activity to the shareholders associated with the activity. While swing pricing seems like a logical method of preventing harm from shareholders looking for the “first mover advantage,” it comes with the burden of increased operational complexities. Swing pricing also comes with significant subjectivity in determining the costs associated with the particular shareholder trade. A considerable amount of judgment would be needed to differentiate the degree at which the additional costs would be due to either the specific shareholder transaction or normal market conditions.
More Disclosures and Reporting
Lastly, the additional disclosure requirement proposed by the liquidity risk management program would provide investors with more information; however, it also could reduce the comparability between funds since the majority of the proposals are fund-specific.
Overall, the proposed liquidity risk management program is aimed at helping to ensure funds can meet their obligations to investors and shareholders. Whether or not investors would actually benefit from the ultimate program is yet to be seen.
For more information on this topic, please visit the ICI Website.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.