Tuesday, January 19, 2016

Pushback on SEC Liquidity Proposals

Author: David Schwartz J.D. CPA

The Securities and Exchange Commission’s September 2015 rule proposals addressing mutual fund liquidity issues have not been received with great enthusiasm by the fund industry.  Some major players have made it quite clear in their comment letters that they feel the SEC has missed the mark with this proposal.  


The Proposal


The SEC proposal, if adopted, would require mutual funds and ETFs to implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. In addition, the proposed rules would allow registered investment companies to use “swing pricing,” a process of adjusting the net asset value of a fund’s shares to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity.  

In addition to codifying the 15 percent limit on illiquid assets already included in current Commission guidelines, the proposed rules would require a fund’s liquidity risk management program to contain multiple elements, including:

  1. classification of the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact;
  2. assessment, periodic review and management of a fund’s liquidity risk; 
  3. establishment of a fund’s three-day liquid asset minimum; and
  4. board approval and review.




Thus far, there are sixty-nine comment letters on the proposal.  While they are almost unanimous in their approval in principle for the SEC’s interest in mutual fund liquidity issues, the vast majority are critical, sometimes adamantly so, of at least one aspect of the approach taken.  


By far, the greatest objections were for the asset classification scheme.  For example, SIFMA expressed concerns that certain components of the SEC’s Proposal would actually impede the SEC’s understanding of fund liquidity and undermine effective liquidity management practices.  SIFMA’s letter argues that the proposed classification system would require funds to make finely tuned distinctions about the liquidity of specific holdings, or portions of holdings, at a given point in time, creating the impression of precision and objectivity. But according to SIFMA, these distinctions would, in reality, be subjective and often arbitrary.


The Investment Company Institute echoes these objections to the asset classification scheme in the proposal.  Like SIFMA, the ICI believes such a system would not only hinder understanding of mutual fund liquidity, but would also negatively affect investor behavior. 


“. . . the Institute must oppose the Release’s very specific and prescriptive elements: the asset classification scheme and the “three-day liquid asset minimum.” Those elements simply do not comport with sound risk management practices. If adopted, these elements could:


  • Direct funds toward a one-size-fits-all approach to liquidity management with an unproven methodology that, as best we can determine, no fund uses today;
  • Distort portfolio management, hamper returns, and inflate tracking error by requiring funds to maintain a cash cushion that in many cases would be larger than a fund would otherwise hold and by limiting funds’ ability to adjust to new investment opportunities;
  • Encourage fund managers to rely upon third-party vendors to handle the gargantuan, ongoing task of assigning liquidity classifications to many thousands of individual securities, thus giving rise to “liquidity rating agencies,” much as previous SEC regulations helped advance credit rating agencies;
  • Introduce new risks to fund shareholders and the financial system by increasing the correlation of fund portfolios and trading—inducing the sort of “herding” behavior that has never before characterized the fund market; and
  • Misrepresent the liquidity of funds, mechanically making large funds appear to be less liquid regardless of the assets they hold or the redemption demands they are likely to face. 


So strong were the ICI’s objections to the proposal, that it sent a second comment letter from the ICI’s Chief Economist, Brian K. Reid, reinforcing its earlier objections with data analysis, and soundly criticizing the three-day liquid asset minimum proposal.  According to Mr. Reid, the proposed three-day liquid asset minimum risks creating the exact scenario the Rule Proposal seeks to ameliorate, positing that:


"During a market downturn if a fund’s liquid assets fall toward the established minimum, the fund’s adviser may sell less liquid securities in order to remain above the minimum, potentially undermining liquidity in certain market segments, instead of bolstering it. Moreover, if the fund sells these less liquid securities at prices below fundamental value, fund investors could be harmed."


Capital Research and Management, one of the largest fund groups in the US, shared ICI and SIFMA’s concerns about the proposal’s potential to do more harm than good.  With every fund using a slightly different standard for classification, the imprecision of the system would make it useless: 


"Most significantly, we note that the proposed classification categories imply a level of precision in making determinations that does not exist. We agree that codifying the factors required to be considered in making liquidity determinations will contribute to more consistency in the quality and breadth of funds’ analyses of their portfolio positions’ liquidity; however, we are concerned that different funds could classify the liquidity of identical portfolio positions differently. We would emphasize that liquidity is dynamic and that liquidity determinations are inherently uncertain, particularly for debt securities and other instruments that trade over-the-counter. Funds may also vary in how they interpret and weigh the factors required to be considered in making liquidity determinations, which will likely lead funds to assess liquidity for the same assets differently."


Board Oversight and Swing Pricing


Commenters were predominantly in favor of the proposal to implement liquidity risk management programs and board oversight of liquidity risk management, with the Mutual Fund Directors Forum and the ICI’s Independent Directors Council, respectively, warning that directors need not be expected to actively manage liquidity risk, merely oversee its management.


 ". .  .we believe that the Commission and others must consistently be mindful of the board’s oversight role and not expand the role of directors in a manner that makes them responsible for directly managing risk or that judges the performance of the board or of the risk management program it oversees in hindsight."


Swing pricing, on the other hand, was a bit more controversial.  Swing pricing for single price funds like mutual funds is a way to reduce the negative effects (i.e., trading costs) on existing fund investors of large purchases or redemptions. The principle underlying swing pricing is that investors transacting at a volume that could materially affect other investors in the fund should bear their own trading costs.  Because determination of the swing price is related to whether the fund is in a net inflow or net outflow position, some commenters, including Capital Research and Management, suggested that implementation of swing pricing for mutual funds should be delayed to allow the industry to improve its data architecture.  Commenters pointed out that, because mutual funds must strike a NAV at 4:00pm daily, under the present data architecture the appropriate net inflow/outflow data may not be available timely to calculate the day’s swing price.  


Others, like Federated Investors, feel that the swing pricing proposal is fatally flawed and its implementation would be harmful.  Chief among their concerns are that swing pricing may not have a beneficial effect on systematic risk, could result in the favoring some fund investors over others, could lead to increased volatility in fund performance and unnecessary randomness in both reported performance and in realized returns for individual investors, and could lead to efforts to game trading in a manner that would harm investors and mutual funds.  generally.


Though swing pricing as proposed would be optional, many commenters felt that even providing the option would ultimately drive all funds to use swing pricing when necessary.  


The comment period for this proposal closed on January 13, 2016, but the debate is far from over.  Given how far reaching these proposals are, no doubt the Commission’s staff is listening closely to the industry’s reactions.