The SEC's Proposal on Fund Liquidity Is a Work in Progress

Trading Places This May, the SEC released the first of a series of proposals that aim to improve mutual fund reporting. That measure addressed how funds report their holdings and seemed to me to be an unalloyed good.

Last month, the SEC published its second proposal; the subject was "liquidity risk management." This proposal covers both traditional mutual funds and exchange-traded funds but not money market funds, which are covered by their own, stricter rules. This new measure is also a positive, but, unlike May's effort, it carries some cons as well as pros.

Highlights 1) Liquidity buckets

Funds would be obliged to sort their holdings into one of six liquidity classifications, ranging from "convertible to cash within 1 business day" at the most liquid to "convertible to cash in more than 30 calendar days" for the sixth bucket. For the most part (the exception comes next), these classifications would not be used to restrict fund behavior but rather for risk management and disclosure.

Risk management would be an internal program, with a fund’s board required to approve a policy statement for how the fund’s liquidity will be managed and then review the portfolio annually to ensure compliance. Disclosure, of course, would be for external reasons, so that shareholders and other interested parties could see the liquidity information that the board receives.

2) A 15% cap on illiquid assets

This would be a new requirement, but it is not a new idea. In 1992, the SEC raised the informal limit that it had placed on illiquid assets in mutual fund portfolios to 15% from 10%. (That it was an election year was no coincidence. The rationale for the change, per the SEC's own words at a time when President Bush was stumping on reducing regulation and helping Main Street, was to "provide small businesses with better access to the capital markets.")

This informal limit would now be codified and the concept of illiquid assets broadened. Once thought of primarily as restricted securities--that is, as private-placement issues that were not traded on a public market--illiquid assets now means to the SEC any security that cannot be sold "in the ordinary course of business within seven calendar days at approximately the value ascribed to it by the fund."

3) Swing pricing

Swing pricing is a mechanism for penalizing fund shareholders who rush for the doors. With swing pricing, once a fund is asked to meet more redemptions than are permitted by a specified threshold, the price paid to shareholders who are selling their shares declines. That is, the fund’s net asset value is marked down to reflect the cost of raising cash (the cost being the expected discount on the fund’s securities as management conducts a forced sale).

Swing pricing can also work in the other direction, with the fund charging incoming investors a higher-than-quoted NAV to reflect the cost of putting those new assets to work. In practice, though, that would seem unlikely, as the situation is not truly reversed. Unlike funds that are being heavily redeemed, funds that are being heavily purchased may close their doors. Also, if they stay open, they can take their time in investing the new cash, whereas funds that are being redeemed do not enjoy the same luxury in paying off shareholders.

My Thoughts 1) Liquidity buckets: Great idea--but can it be done correctly?

No question, liquidity is an important subject.

Many bond funds (the tactic is much less common with stock funds) seek higher returns by buying less-liquid securities. As compensation for their trading flaws, these securities pay a relatively high yield and thus offer a better total return than liquid issues during normal market conditions. They are no fun to hold during a panic, though. Buyers disappear, the bonds’ prices plummet, and anybody who is unfortunate enough to be a forced seller will suffer large losses.

All that is as it should be. Extra return is supposed to be associated with extra risk. But the risk of low liquidity tends to be hidden. It is not visible during the calm weather, when all the boats are floating. It only appears in a fund's performance when the storm arrives. This historically has led to many bond-fund surprises, with shareholders--and sometimes fund boards as well--learning to their shock that the fund was something other than what they had thought. Mandating liquidity classifications should help greatly in avoiding such confusion.

But getting the details right will be tricky. As demonstrated by The Wall Street Journal's September story on bond-fund liquidity, which had the Investment Company Institute (the fund trade organization) squawking in indignation, forming bond-liquidity groups is not a simple matter. Morningstar's bond-fund analysts have some concerns about the SEC's suggestions; they will share their concerns in a forthcoming article.

A 15% cap on illiquid assets

Back in the day, the SEC had a 10% limit on restricted securities for both money market and conventional mutual funds. In recent decades, it has shrunk the money market allotment and raised that for conventional funds. The direction makes sense. Money market funds are a different, more tightly controlled investment than are other mutual funds and should therefore be treated by different rules.

I would have preferred that conventional funds remain at 10%, but the 1992 increase has proved to be no big deal. Codifying the current practice should not be, either.

3) Swing pricing: Cuts both ways

Swing pricing sounds good, for both moral and policy reasons. If a shareholder causes a fund to suffer a market loss because of a redemption request, then it seems only fair to have that person pay the bill. Turning to policy, the penalty of swing pricing should deter runs on funds. Today, the rational course for owners of struggling bond funds is to shoot first and ask questions later, so that remaining shareholders foot the bill. It clearly is not a good thing that the aggregate rational decisions lead to a stampede.

Also, while swing pricing has not been used with U.S. mutual funds, it long has been a feature in Europe--apparently with success. Morningstar’s European fund analysts aver that swing pricing has been a positive for their markets.

If this goes through, however, it won’t be trouble-free. Imagine owning a fund, needing to raise assets during a downturn (hardly a far-fetched idea), selling shares to generate the required amount--and then receiving a smaller check than you anticipated because your redemption request pushed the fund past the swing-pricing threshold. Had you made that request one hour earlier, you would have been below that limit and would have received the full net asset value.

Yes, I think you might be upset. You might also decide that swing pricing gives you an even-greater incentive to be the first to the door. Get there before the redemption threshold is reached.

Final Thoughts The SEC has three goals with its liquidity proposal. It wants to prevent bond funds from sparking a market panic by selling securities to meet mass redemptions; it wants to prevent bond funds from assuming risks that management has not considered fully and that the board is not reviewing; and it wants shareholders to better understand the risks that their funds are taking.

The first goal strikes me as mostly pointless; to my knowledge, bond funds have never been the main driver of a market downturn (although with high-yield bond funds in 1990, they certainly were a contributor). The second is sensible, although one can argue that it is somewhat patronizing, as professional managements and boards should already be considering such things. But perhaps the requirement is necessary. The third is the most useful. Getting key information about risks to fund owners is a fine thing indeed.

The SEC promises several future proposals as it reviews its mutual fund rules at the time of the 75th anniversary of the Investment Company Act of 1940. In the first two proposals, the best and most useful features involved disclosure, rather than mandating investment policies. I suspect that the same will hold true for the future proposals.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.