On September 22nd, the Securities Exchange Commission (SEC) voted to propose a “comprehensive package of rule reforms designed to enhance effective liquidity risk management by open-end funds, including mutual funds and exchange-traded funds.” The SEC’s plan aims to supplement the limited regulatory regime over fund liquidity by outlining disclosure requirements for portfolio liquidity and limits on illiquid assets. Currently, mutual funds are expected to honor shareholders’ redemption requests within seven days and guided to cap their investments in illiquid securities at 15 percent. The SEC is concerned with vulnerabilities in the financial system and through its plan seeks to ensure that funds can meet the redemption demands from investors during periods of market turmoil.
SEC Chair Mary Jo White explained that this proposal is “essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds.” According to the Investment Company Institute (ICI), the current estimate of the number of individual investors who own mutual funds is over 90 million, which equates to nearly 30% of the U.S. population. As ICI notes in its FAQs, the majority of investors utilize mutual funds to save for retirement – that is they use mutual funds as long-term investment – but the SEC’s proposal is focused on making the liquidity risk more transparent for investors seeking to “redeem their shares and receive their assets in a timely manner.” So, although liquidity may not be an immediate concern among investors in mutual funds, regulators want investors to be more cognizant of the liquidity risks in funds for future redemption, especially as funds engage in more complex strategies (highlighted in what the SEC refers to as the “Liquidity White Paper”).
While the proposed rules may mark an improvement for the investing public, the Wall Street Journal comments that some analysts warn that the rules mean more costs for fund companies. Under proposed rule 22e-4, mutual funds and other open-end management investment companies would have to establish liquidity risk management programs that consist of:
- Classification of the liquidity of the fund portfolio assets (based on the number of days it takes to convert the underlying assets to cash);
- Assessment, periodic review and management of a fund’s liquidity risk;
- Establishment of a three-day liquid asset minimum; and
- Board approval and review.
The classification and assessment elements require an evaluation of honoring redemption requests under normal conditions and under stressed conditions, without materially affecting the fund’s net asset value (NAV) per a share.
The SEC is also considering permitting funds to use “swing pricing,” which is the “process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders.” This pricing method transfers the trading costs to the shareholders responsible for imposing the trading activity, rather than the costs being borne by the non-redeeming shareholders, which, according to Moody’s, can positively impact a fund’s long-term performance. However, the pricing method may not offset the effect of holding more liquid assets, which has the potential of weaker long-term investment results.