New, sweeping SEC proposals aimed at enhancing the liquidity risk management practices of mutual funds and ETFs have the asset management industry greatly concerned about unintended consequences affecting their businesses.
The SEC's five-member board unanimously voted last week to address criticism that its rules designed to oversee the ever-evolving U.S. fund industry are outdated. This comes after warnings from both the Federal Reserve and the International Monetary Fund that some funds could struggle to meet investor redemptions in a time of market turmoil, Bloomberg reports.
The new proposals would require that funds hold a cash cushion, or liquid investments, that can be sold within three days if necessary. In addition, the regulator has proposed the option of industry-wide redemption fees for shareholders who cash in their investments during market turmoil.
"Promoting stronger liquidity risk management is essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds," says SEC Chairwoman Mary Jo White in a statement following the announcement.
"These significant reforms would require funds to better manage their liquidity risks, give them new tools to meet that requirement, and enhance the Commission's oversight."
For much of the $18 trillion mutual fund industry, currently held by 53% of U.S. households, legally-binding guidelines are already in place to require cash be returned to investors within seven days, according to Bloomberg. The resulting search for higher returns has created a complex web of debt trading which can be difficult to sell during a down-market.
Investment Company Institute President and CEO Paul Schott Stevens says whatever the final decision made by the financial oversight committee would have lasting effects.
"[The SEC's] proposal raises a number of complex issues for funds, their directors, and their investors," says Investment Company Institute President and CEO Paul Schott Stevens in a statement. "We look forward to engaging with the SEC to ensure that any final rules in this area are well-founded, practicable and effective."
Stevens added that he hopes to see SEC Chair White and the Commission will work to ensure that mutual funds, "continue to manage liquidity and redemption risks successfully for years to come."
PASSING ON COSTS
The proposal would require that mutual funds and ETFs adopt liquidity-management plans in order to allow their investments to be quickly turned into cash. The fund's individual boards of directors would then vote on the percentage of which a portfolio must be liquidated.
Also included in the proposal is a plan to provide mutual funds the ability to use swing pricing and allowing asset managers to pass on trading costs to redeeming investors.
Investors currently buy and sell shares of a mutual fund's closing price. Under the proposed implementation of swing pricing, investors would receive a price that is lower than the fund's NAV, which is intended to deter investors from withdrawing their investments during market turmoil, according to Bloomberg.
Sean Tuffy, the head of regulatory intelligence for New York-based financial services firm Brown Brothers Harriman, says the "swing pricing" portion of the proposal could be the most controversial.
"I think that reactions will be mixed and initially - many investors will be a bit skeptical of the idea," Tuffy says. "However, given that swing pricing will be optional, there's unlikely to be a shock or a 'big bang' roll out of the practice."
However, Tuffy points to the success of swing pricing in European mutual funds where swing pricing practices are viewed as an important tool that protects investors from the impact of large inflows or outflows from a particular fund. "The concept has only recently taken on a second life as a potential mitigant against systemic shocks," he adds.
Whether warranted or not, Scott Cooley, director of policy research at Morningstar, also expects to see an initial pull-back from fund managers and shareholders.
"Some will argue that these proposals are unnecessary because funds generally have not been sources of instability in past financial crises," Cooley says. "In fact, I would argue that the fund industry was a significant source of stability, especially in comparison with the large commercial banks and investment banks."
POTENTIAL IMPACT
Erlend Bo, the managing director and head of distribution at Angel Oak Capital Advisors in Atlanta, recalls nearly a decade ago when the SEC considered a 2% industry-wide redemption fee for investors that redeemed within five days. Regarding the current proposal, Bo says he is worried about the potential impact on the cost of doing business.
"It would be very difficult or costly to track all of this to figure out who should be paying a redemption fee and who shouldn't," Bo says." So, it will add significantly to the cost of running a mutual fund by having essentially all mutual funds are subject to this."
This is not to say that Bo is against the idea of implementing redemption fees.
"We don't have a redemption fee, but we do have the right to reject somebody who is engaging in practices like that."
HYPOTHETICAL RISK
Developing a plan for advisors and investors could be an issue, Cooley says.
"You could imagine a situation where a manager implemented these in an unfair way, but I think the SEC is going to demand that there be a good policy in place."
For regulators, one concern could be that funds with a lot of illiquid assets may cause panic, he suggests, but adds the risk is a hypothetical one and the proposals are intended to protect the long-term shareholder.
"There could be a person who has owned an investment for 10 years and happens to be selling on the day when other people are panicking and they can get hit with the charge," Cooley says. "That's unfortunate, but I think the benefits of the initiative would outweigh the cost."
Tuffy doesn't expect the regulatory proposals "to be met with hostility."
"Overall, I think the industry will be receptive to the SEC's proposals," Tuffy says. "Of course, there will still be debate about the final shape of the rules."
