The goal of the US Securities and Exchange Commission’s new proposed rules for swing pricing for mutual funds may be noble, but their potential implementation is already causing plenty of strife, say operations insiders.
A swing price, according to the US regulatory agency is an adjustment to the net asset value, based on a huge purchase or redemption order. The new artificial price is meant to protect the “last-man-standing” investors from being penalized for continuing to hold the shares.
That may be good news for some shareholders. Not so for valuation teams, which are faced with hard work and harder decisions. “The lines of the internal battlefield are being drawn and it’s going to be difficult to get to a consensus about how swing pricing will work,” says a fund accounting manager of a US fund complex.
The new proposed rules require fund managers to have sufficient liquid assets on hand to handle large redemption orders. They also allow mutual funds to change current fund pricing rules, which could harm investors who remain in a fund after a sell-off, says a September report by Barclays Plc. The reason: investors who sells their shares on days when a lot of cash leaves a fund get an inflated price. After the fund estimates the new price for less liquid assets in its portfolio, the fund’s asset value declines afterward, especially when the higher proportion of remaining illiquid assets is factored in.
The new pricing policies, which must be disclosed to the SEC, would supposedly curb the impulse of investors to stampede out of mutual funds , because those investors could receive less than the last NAV. Swing pricing would be implemented, pending board approval, if the level of net purchases or net redemptions from the fund exceeds a threshold percentage of the fund’s NAV.
“The most significant operational burden will be on fund accountants to implement a difference in NAV calculations for the days swing pricing is triggered,” says Matthew Bromberg, a partner with the law firm of Reed Smith in New York. “Obviously, there will be additional burdens placed on legal and compliance groups in developing documentation policies and disclosure.” Funds must explain their swing pricing policies to the SEC on Form N-1A and to investors on the financial highlights section of the fund’s financial statements.
European Twist
Swing pricing isn’t exactly a new concept. What is new is its potential widespread acceptance in the US. A survey of 19 fund managers conducted by the Association of the Luxembourg Fund Industry, which has set guidelines for swing pricing, touted the benefits of swing pricing for investors and the fund itself. Those who didn’t implement swing pricing cited operational complexity as one of the key factors for their decision. The operational difficulties could be more substantial for smaller-sized funds than larger ones, say fund accountants.
European funds implementing swing pricing might take into account only the direct explicit transaction costs applicable to large redemptions or purchases and not necessarily price impacts when adjusting the fund’s NAV. “It will be interesting to see if swing pricing in the US will mirror that of European funds and only at the transaction cost level, or if US funds will incorporate the more difficult and material impact of market movements related to large purchases or redemptions,” says David Larsen, managing director of valuation specialist Duff & Phelps in San Francisco.
Five of the ten US mutual fund compliance managers contacted by FinOps say their valuation committees are holding weekly meetings to decide the “threshold” for implementing the practice of swing pricing and how they will determine the swing factor or the final swing price itself. “Boards of directors are urging fund management firms to use a high barometer, so swing pricing would be applied only in extreme cases,” says one compliance manager. The threshold refers to the change in the percentage of the fund’s NAV caused by the level of net purchases or net redemptions from the fund.
Just how high is too high? Nobody knows. Fund management firms typically rely on valuation committees to come up with the correct methodology and inputs to use when pricing each of their assets. “The net asset value represents a mathematical combination of the fair value prices of each of the assets in the portfolio,” explains Larsen. “Those fair value prices reflect either the closing price on which an asset is traded on an exchange or if not exchange-traded, the pricing models and inputs agreed by the valuation committee.”
That’s not the case with swing pricing ,which has to take into affect the impact of the large redemption or purchase order on the NAV of the fund. Here is how swing pricing could be applied, explains Larsen, using the simple example of a mutual fund with investments in a single share type. An investor wants to redeem a large portion of its holdings in a mutual fund which holds shares only of one blue-chip company. To come up with the cash, the fund management company has to sell a block of shares. Under today’s environment, the investor would receive the last price of the fund shares reflecting the last NAV struck the previous night. That could be US$10 a share. That’s not necessarily the price at which the fund management company might have sold the shares at different intervals, because it would not have been able to dispose of them all at once. Because of market response to the size of the block sale, the mutual fund company may have had to accept only US$9 for some of the shares.
So what price should the investor with the large redemption request receive? With swing pricing, he could receive less than US$10 a share, maybe even as little as US$9 a share. And what about other investors who also want to redeem their shares on the same day? They would receive the US$10 a share. Taking the same example using a large purchase order. Instead of paying the previous day’s NAV of US$10 a share, the investor might have to pay a slightly higher pricetag — perhaps US$11– if the fund manager would have had to pay more than US$10 to buy the shares. The other investors would still pay the US$10 a share.
Practical Tips
What should a fund management firm do to prepare for swing pricing? It’s now time to take out the high-velocity calculators to do some scenario testing using different thresholds which might trigger the practice swing pricing. Also critical is evaluating the pricing models and inputs for calculating the swing price, recommend valuation experts at two fund management shops. “The key will be to ultimately arrive at an agreement on how the swing NAV is calculated, what costs are considered and when the swing pricing mechanism is triggered,” says Bromberg. “Some of the costs, such as market impact, will be more difficult to determine precisely and will require more judgement.”
The ultimate approach taken, he believes, must be implemented consistently. A separate committee may even be set up to determine the swing pricing parameters and meet periodically to review the parameters and how effectively the policies can be executed.
Once an internal consensus is reached it’s time to brace for the second battle: the one with the board of directors, which must sign off. Warns one valuation manager, “If you think coming up with internal policies on swing pricing is hard, try explaining it to a board of directors who might already have enough trouble understanding fair value pricing. Plan on using the whiteboard and lots of colored pens.”
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