Investors trust open-ended mutual funds because they promise easy entry and exit. We think proposed new liquidity rules should help fund managers deliver on that promise.
In September, the SEC unanimously approved a plan that would require funds to disclose additional information about their liquidity risk and to maintain a minimum level of assets that could be sold within three business days. Some of the details need fine tuning. But overall, we think the proposal is step in the right direction.
Mutual funds are legally required to return cash to their investors within seven days. In recent years, some funds have invested in larger shares of less liquid assets in an effort to boost returns. Given today’s low-interest-rate environment, that may make sense. But investors should know how their money is being invested.
Here are a few of our thoughts on the proposal:
Liquidity “buckets” should enhance transparency and liquidity. The SEC proposal calls for grouping assets into six buckets, ranging from “convertible to cash in one business day” to “convertible to cash in more than 30 calendar days.”
This echoes the approach we’ve been using for years to manage liquidity risk. It puts fund managers in a position to meet redemptions during times of stress and to buy attractive assets when others are desperate to sell. That’s good news for a fund’s shareholders and for the broader bond market.
Why? Because the $16 trillion mutual fund industry has replaced the banks as the market’s primary liquidity provider. As we’ve pointed out, a stricter regulatory environment for banks is one of several important trends that have drained bond market liquidity in recent years. In the past, investors who wanted to sell bonds in a hurry could usually rely on Wall Street dealers to step in and buy them. That kept price fluctuations in check, especially during times of stress.
Mutual funds should be playing this role today. That would be good for bond market liquidity and, potentially, their own returns.
Swing pricing can protect shareholders from dilution. The proposal would let mutual funds use swing pricing—the ability to charge investors more to enter or exit a fund on days of high inflows or outflows.
For instance, if a fund should be hit with a wave of redemption orders on a given day, it could mark down the fund’s net asset value (NAV) slightly for those who want to sell. This would compensate for the cost of raising cash. When such swing pricing isn’t used, existing shareholders are left to absorb those costs.
The SEC seems to think this approach would dissuade investors from rushing to sell during times of stress. But it could work the other way, too. When demand for a fund was high, managers would be able to charge incoming investors a slightly higher NAV—again, to prevent existing shareholders from shouldering the trading costs.
In our view, swing pricing offers fund managers flexibility and can spread costs more equitably among shareholders. It is widely used in Europe—and works well. Time will tell if it can win broad acceptance in the US.
Some markets may have to reform. Stricter liquidity rules would be more difficult for some funds than others. Among the potential losers are leveraged bank loan mutual funds. It takes an average of 20 business days to settle a loan trade.
That would make it hard for such a fund to comply with the SEC’s proposal to codify an existing guideline that says only 15% of a fund can be invested in illiquid assets—described as securities that can’t be sold within the normal course of seven calendar days “at approximately the value ascribed to it by the fund.”
Some fixed-income exchange-traded funds, which are subject to some of the proposed SEC liquidity rules, might struggle to comply, too—particularly those that invest in less liquid markets such as high yield.
There are some points that still require discussion. But overall, we think the SEC’s approach to liquidity risk is reasonable. Mutual funds aren’t hedge funds. They’re not supposed to be high-risk vehicles for elite, seasoned investors. Mutual fund investors have a right to understand how their money is being invested and the risks that come with it.
