If the tone of discussions at a recent standing-room-only event hosted in New York City by the Association of the Luxembourg Fund Industry (ALFI) is any indication, the answer is they’re actively searching for information so they can swing into action.
Topping the list of concerns expressed by representatives of US fund complexes are the availability and timing of information about net flows of subscription and redemption requests. That information is necessary for the mutual funds’ accounting departments to match the numbers to the thresholds that trigger swing pricing. Such interim changes to share price will only occur if the level of net purchases or net redemptions exceeds a specified percentage of the net asset value (NAV).
The concept of swing pricing — an adjustment to the official net asset value and thus the share price — isn’t a new one. It has already been implemented in Europe for at least five years, predominately by Luxembourg-domiciled UCITS-eligible funds of some mega US fund complexes. In fact, 30 out of 45 European fund management firms polled by ALFI earlier this year reported they had used swing pricing. However, the practice has not been embraced by US-domiciled funds.
The official encouragement to use swing pricing when necessary is part of a broader reform package the US Securities and Exchange Commission has proposed for open-ended funds. The SEC wants to ensure that mutual fund companies are fair to their loyal buy-and-hold investors and protect them from being penalized in favor of active traders that purchase or sell large blocks of shares.
Another of the proposed rules is aimed at insuring that mutual fund complexes aren’t caught flatfooted when an investor suddenly wants to redeem a large block of shares. To that end, the US regulatory agency has recommended that mutual funds established a liquidity management programs to monitor asset quality and availability to minimize damage to NAV of a sudden large block redemption.
While no one at the ALFI event would disclose their secret sauce — the procedures used by their firm to execute swing pricing — the general consensus was efficiency of workflow process in moving information was critical. The wrong information or lack of information in the hands of the fund management’s accounting group could spell disaster — either the threshold would be incorrectly overlooked when it was reached, or the swing pricing would be calculated incorrectly. Is this likely to happen? Again, no one would predict a how often this scenario might occur, but one of the panelists did remind the group that stringent accuracy is required.
Although having automated and standardized data formats in data exchange may help ensure accuracy, timing is just as important, according to Philippe Ringard, executive director of JP Morgan Asset Management in Luxembourg. There are no regulatory guidelines in the US for what time mutual fund complexes must receive net cash flow information. To implement swing pricing, those complexes may have to work with their distributors to get more timely information.
“The transfer agent must obtain the information on net cash flows from all of its distributors by a certain time and forward the information to the fund complex’s accounting department to determine whether the threshold has been reached,” says John Schiavetta, senior vice president of risk management for Alliance Bernstein who spoke at a panel on swing pricing at the ALFI event. However, the information, he cautions, is likely to be an estimate. “The net cash flow data doesn’t have to be perfect and the SEC’s proposal suggests that the fund management complex’s accounting department can make the determination after a reasonable inquiry.”
Why isn’t the data perfect? The fund management complex may need to rely on interim flows. Based on the current US working environment, the fund management shop doesn’t know final net cash flows until after a fund’s NAV is struck. “To implement swing pricing in the US, the fund complex would need to know the net flow data earlier in the day than is currently the case,” explains Schiavetta.
Of course, the fund accounting department must be able to quickly to come up with the swing price by calculating the “swing factor” — that is, the projected costs to the fund and other investors of the large redemption or subscription. Those considerations may include transaction costs and the projected market impact of the large redemption or purchase.
Denise Voss, chairman of ALFI, suggests that fund complexes consider a cap — a maximum amount that the NAV can move from mid price towards either the bid or offer price. “The reason to put a cap in place is so investors can have an expectation of the maximum movement that the NAV could be impacted by the swing factor.” Regulators will also be reassured that the adjustment has a hard limit.
What should the maximum swing be? Although different funds are likely to select different caps, Voss believes that 200 basis points — a common metric in Luxembourg-domiciled funds — would take into account most circumstances, barring a liquidity crisis.
Not only must the fund accounting department know just what the threshold and factors should be, but also what circumstances might change the threshold and swing factor and when they should be changed. Enter the swing pricing governance committee which should consist of transfer agents, fund accountants and other valuation experts, says Voss, who is also chief conducting officer for Franklin Templeton Investments in Luxembourg.
US mutual fund complexes may decide rely on a single swing pricing governance body, that doesn’t mean that the same threshold should apply to each fund. “The determination needs to be made based on the investment strategy of each fund and market volatility,” says Voss. Case in point: a fund specializing in one or more emerging markets might have a lower threshold than a fund which invests in US government bonds.
In addition, the threshold and factors are not necessarily set in stone, and will be reviewed. In Europe, swing pricing committees typically meet on a quarterly basis, or sooner to address rising challenges like an overall market downturn or major change in transaction costs, according Matthew Bromberg, a partner at law firm Reed Smith.
Mutual fund complexes must be able to defend their policies. The details of thresholds and factors, as well as the circumstances under which they might change, should be well-documented for regulatory scrutiny.
As for what to tell investors, less is apparently more. Some experts advise that investor be told only that swing pricing may be implemented. “We won’t disclose thresholds to avoid investment arbitrage,”says Ringard, also a panelist at the ALFI-hosted event.
What is the most complicated task involved with swing pricing? Coming up with a threshold that’s fair to the investors, according to most participants at the event who spoke with FinOps Report.
“You need to come up with a reasonable threshold that won’t be too high and not too low,” says Bromberg. “If the threshold is too high the swing price will not achieve its intended goal of offsetting transactional costs that are dilutive. If the threshold is too low, it means that the NAV volatility which takes place would not likely be warranted to offset minimal transaction costs which are not likely to be dilutive.”