Mutual Funds and ETFs: A New Liquidity Risk Management Regime
On October 13, 2016, the SEC unanimously approved rules requiring open-end funds, including mutual funds and exchange traded funds (“ETFs”), to adopt liquidity risk management programs and permit mutual funds to use “swing pricing,” subject to specific requirements.(1) The Commission also enhanced data reporting requirements for mutual funds and ETFs.
Open-end funds are an attractive investment option for many different types of investors because they provide diversification, economies of scale and professional management. They also facilitate retail investors’ access to certain investment strategies or markets that might be difficult, too time-consuming, or impossible for investors to replicate on their own. In recent years, retail investors have increasingly relied on investments in open-end funds for saving for life events, such as retirement or a child’s college education. Institutional investors have also gravitated to open-end funds as part of their trading and hedging strategies. As recently as 2014, investors hold over $12 trillion in mutual fund assets.(2)
This broad investor interest has prompted liquidity concerns by regulators in the event of a crisis. The Financial Stability Oversight Council (“FSOC”) expressed particular concerns about the ability of mutual funds to sell shares during a crisis. In September 2015, the SEC, whose chairman is a voting member of the FSOC, proposed the new rule requiring most open-end funds to adopt a liquidity risk management program. Mutual fund liquidity concerns came more into focus in December 2015 when a prominent New York mutual fund containing large junk bond positions plummeted in value, prompting the fund to take the rare step of halting redemptions while winding down the fund through the disposition of assets at “fire sale” prices. The SEC is concerned that investor redemption rights may be compromised with more illiquid mutual funds or ETFs. Given recent developments, open-end funds with fewer liquid assets are viewed as especially vulnerable.
COMPONENTS OF THE LIQUIDITY RISK MANAGEMENT RULE
The SEC’s rule can be broken down into 3 primary categories:
- Adoption of a liquidity risk program;
- Use of swing pricing; and
- Additional liquidity risk disclosures.
Liquidity Risk Program
The Commission seeks to promote liquidity risk management standards in open-end funds to address issues arising from modern portfolio construction of open-end funds, particularly funds investing in more illiquid securities. Under the new rule, the SEC will generally require an open-end fund’s liquidity risk program to include the following:
- Assessment, management and periodic review of liquidity risk;
- Classification of liquidity of fund portfolio investments into the following 4 categories based on the ability to convert into cash without significantly altering the investment’s market value:
- Highly liquid: can be converted into cash in 3 business days;
- Moderately liquid: can be converted into cash in 4 to 7 calendar days;
- Less Liquid: can be sold or disposed of in 7 calendar days, but settlement may take longer; and
- Illiquid: cannot be sold in 7 calendar days;
- Determination by each fund of a highly liquid asset minimum;
- Annual reports to the board on the highly liquid asset minimum annually, and any time the fund fell below the minimum threshold;
- 15% limit on illiquid investments;
- Monthly review of illiquid investments;
- Reporting and remediation of breaches of the 15% Illiquid Investment Limit;
- Board oversight of liquidity risk management program; and
- Filing of Form N-LIQUID for breaches of the illiquid investment limit.
Swing pricing is the practice of allocating transaction costs of trading activity to the most active traders, and functions as an anti-dilution tool used to adjust a fund’s net asset value (“NAV”) in order to protect existing shareholders from purchases and redemptions. The new rule permits mutual funds (but not ETFs or money market funds) to use swing pricing to help manage liquidity risks providedthattheir policies and procedures:
- Document the process for determining:
- Swing threshold – a pre-determined percentage of fund’s NAV based on asset class and capital activity of the fund;
- Swing factor – a specified amount to adjust the NAV once the level of inflows or outflows are determined;
- Establish an upper limit on the swing factor, not to exceed 2% of the NAV per share;
- Be approved by the fund’s board; and
- Be required to periodically review its swing policy for the adequacy and effectiveness of implementation. Any changes to the swing factor’s upper limit or the swing threshold must be approved by the board.
Enhanced Reporting Requirements
Under the new rule, the SEC has implemented new reporting requirements for registered investment companies with the purpose of enhancing the quality of information available to investors. The SEC will also collect and use the reported data to perform more targeted examinations.
The following is a summary of the new and enhanced reporting requirements:
- Form N-PORT: This form requires registered funds (except money market funds) to provide monthly reporting via a structured data format of the fund’s investments. The information collected will include:
- Classification for each investment across the 4 liquidity risk categories;
- Aggregate percentage of fund in each of the 4 liquidity categories;
- Highly liquid minimum; and
- Percentage of highly liquid investments segregated to cover derivatives.
- Form N-CEN: The new form would require all registered investment companies to report census information through a structured data format, including:
- Deployment of lines of credit;
- Inter-fund borrowing and lending; and
- Whether an ETF qualifies as an “in-kind” ETF.
- Form N-LIQUID: The new form would require investment companies, including in-kind ETFs, to confidentially report when a fund’s illiquid assets exceed the 15% limit.
- Fund Financial Statements: Funds will be required to provide enhanced reporting in financial statements, including information on derivatives; and
- Enhanced Securities Lending Disclosures: Funds will need to disclose fees paid to securities lending agents in registration statements.
There are currently 2 kinds of open-end funds largely affected by this rule: mutual funds and ETFs.(3) Since open-end funds are considered to be redeemable securities, Section 22(e) of the Investment Company Act of 1940 (“IC Act”) requires them to make payments to shareholders for securities tendered for redemption within 7 days of their tender, except in extraordinary circumstances. In actual practice, mutual funds typically pay on a next day basis, while ETFs follow the broker-dealer “regular way” settlement process (currently T+3, but expected to change to T+2). Under the IC Act, shares must be redeemed at a price approximately their proportionate share of the fund’s net asset value at the time of redemption.(4)
Open-end funds with highly liquid assets, such as investment grade equities and bonds, are unlikely to be significantly affected by the proposal because they can more easily meet redemption requests within the 7 day deadline. Nevertheless, severe market conditions, similar to the 2008 financial crisis, could impact funds containing a large percentage of securities normally deemed highly liquid.
The rule will impact personnel responsible for managing liquidity risk. Portfolio managers and traders certainly have significant roles with respect to managing liquidity, but risk and compliance managers will have more responsibilities. Risk managers usually have periodic reporting to risk committees to ensure senior management receives adequate information to guide a fund’s liquidity practices. Compliance officers are charged with the duties of administering policies and procedures, which may include compliance with liquidity parameters. Most importantly, a strong governance structure will allow all firm personnel to properly manage a fund’s liquidity and meet the requirements of the proposed rule.
Most funds must comply with the new rule and file Forms N-PORT and N-CEN by December 1, 2018. Fund complexes with less than $1 billion in net assets will be required to comply the rules and file the Form N-PORT by June 1, 2019. To meet the requirements of the rule, mutual fund and ETF managers should be addressing several practical issues, including but not limited to:
- Assessment of current liquidity levels of fund assets;
- Classification of assets into liquidity buckets;
- Determining proper level of minimum liquid asset thresholds;
- Creating liquidity risk management policies and procedures; and
- Considering the use of additional liquidity risk management techniques (e.g., swing pricing, collateral management, committed credit lines, etc.).
Fund managers should be preparing their liquidity risk policies and implementing the governance framework in advance of the deadlines.
(1) 17 CFR Parts 210, 270, 274, Release Nos. 33-10233; IC-32315; File No. S7-16-15.
(2) September 2015, SEC’s Division of Economic and Risk Analysis (“DERA”). DERA noted that assets held by U.S. mutual funds grew from $4.4 trillion to $12.7 trillion between 2000 and 2014.
(3) Money market funds are another type of open-end fund but there are already subject to rule 2a-7 and are largely excluded from this rule and discussion.
(4) 15 U.S.C. Section 80a-2 (a)(32) defining “redeemable security” under the IC Act.
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