The Securities and Exchange Commission recently proposed rules around swing pricing amendments for mutual funds. In short, swing pricing is an investor anti-dilution tool. The SEC’s justification for considering this rule is that existing shareholders in a fund can be adversely affected by the cash flows associated with net purchases and redemptions. This effective dilution was increasingly apparent during the market volatility of 2020 when net redemptions in some funds significantly affected the existing long-term investor.
The investors who benefited were the ones who exited a fund ahead of other investors and therefore achieved a superior net economic price, as the remaining investors bore the exit cost of these investors as captured in the trued-up net asset value. Therefore, the SEC believes that the transaction costs of buying and selling assets to meet net flows—especially in volatile markets—coupled with taxes and brokers fees should be borne by those buying or selling. Under the proposal, investors would no longer be guaranteed the NAV per share for their transaction. Instead, they could receive a price higher or lower than the NAV depending on whether swing pricing was applied while they entered or exited the fund.
The implementation of swing pricing is honorable in its effort to protect existing shareholders. I am confident that if implemented in a transparent manner—clearly disclosed and understood by investors and intermediaries representing the investor—this measure would not be detrimental to the popularity or use of mutual funds.
I am the former CEO of a wealth advisory firm and witnessed firsthand the impact of the rush of mutual fund redemptions in 2020. Funds needed to sell positions that had gains, thereby creating a significant tax burden to those who were still holding the fund at the end of the year. I also have been in leadership positions at two mutual fund complexes and have experienced the impact of redemptions on the resulting net NAV. The detrimental impact to the remaining NAV was especially pronounced in the case of fixed-income funds where bid-ask spreads can be particularly wide depending on the issue and market volatility; this affects existing shareholders and overall fund performance.
New, Smaller Funds
A counterpoint to this rule proposal is the negative operational impact it would have on new mutual fund entrants and existing smaller funds. The cost of implementing such a program would be significant and add to perpetually increasing costs for up-and-coming advisers that otherwise could introduce creativity, new ideas, diversity, and added value to the industry. These new entrants are exactly the kind of candidates we want entering the industry to keep it thriving and current.
Smaller funds have the issue of dealing with the “law of small numbers.” The added costs of implementing swing pricing would be distributed across a smaller asset base, thereby having a greater impact on fees. This is a difficult position for these organizations, as they need good performance to grow their assets. However, it is recognized that these groups are often the ones that need swing pricing the most due to the impact of a large purchase or redemption on a small fund.
Most larger fund groups have the depth of management team and modeling capabilities to take on this task of valuing and measuring the impact of net purchases or redemptions and their associated costs. Many of the global fund groups such as Vanguard and BlackRock have already implemented swing pricing due to international standards on liquidity management, particularly in Europe. Although there are differences in application across jurisdictions and among asset managers, we can learn what has worked well and those areas that need attention and improvement.
Implementation of swing pricing should be approached on an affordability basis. Allow smaller fund groups the option to postpone implementation of swing pricing until they reach a size where the costs would not have significant impact on the expense ratio of the fund. These smaller funds can and should utilize other mechanisms to protect their shareholders. These mechanisms can—and should—include, but not be limited to, suspending redemptions, gating, imposing a transaction fee, or rather than a cash redemption, deliver securities in kind over a certain redemption threshold.
Regardless of how the SEC decides to rule on its swing pricing proposal, mutual fund board members should be asking the fund's portfolio managers to review and report on the impact of historical periods of redemptions and purchases on the NAV. Boards should be asking for their advisers to prepare a forward-looking analysis of possible portfolio allocations and the subsequent impact on NAV in a variety of scenarios. Boards will want to consider measures to lessen the impact upon the NAV under adverse scenarios to protect the existing shareholders.
Susan J. Templeton is an advisory board member for venture capital fund Seyen Capital, an independent director for Claridges Trust Company, and retiring vice chair of Sebold Capital Management. She founded Stafford Wells Advisors in July 2008 and was a managing partner there until April 2019. She previously held senior roles at William Blair Funds and The Newton Funds.