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SEC Wants to Stem Liquidity Risk of Open-End Funds, ETFs

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The Securities and Exchange Commission issued for public comment Tuesday a new rule requiring open-end investment companies, including mutual funds and exchange-traded funds, to establish a liquidity risk management program tailored to their specific portfolio and risks.

Under the plan, which SEC Chairwoman Mary Jo White said furthers the agency’s focus on regulating the asset management industry, open-end funds would also be allowed to use “swing pricing” under certain circumstances and “enhance disclosures” about the liquidity of a fund’s holdings and its liquidity risk management practices.

“Changes in the modern asset management industry call on us to now look anew at liquidity management in funds and propose reforms that will better protect investors and maintain market integrity,” White said during the open meeting at SEC headquarters in Washington.

White noted the “defining feature” of so-called open-end funds is that investors can redeem their shares on each business day and must receive their assets within seven days. “Many funds promise – and many investors expect – to receive their assets even more quickly.”

Since liquidity is therefore “essential,” she continued, “a fund must manage the liquidity of its portfolio to ensure that redemption requests can be fulfilled in a timely manner while also minimizing the impact of those redemptions on the fund’s remaining shareholders.” Poor liquidity management, she added, “can dilute existing shareholders’ interests, negatively impact the value of the fund’s assets or the fund’s risk profile, or cause an ETF’s share price to diverge from the value of its underlying securities.”

A fund’s liquidity risk management program would be required to contain the following:

— Classify the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact;

— Assess as well as conduct periodic review and management of a fund’s liquidity risk; 

— Establish a fund’s three-day liquid asset minimum, and board approval and review. 

— Codify the 15% limit on illiquid assets included in current Commission guidelines.

The SEC’s proposed rule would also provide a framework under which mutual funds could elect to use “swing pricing” to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity. 

Swing pricing would enable mutual funds, subject to board approval and oversight, to reflect in a fund’s net asset value (NAV) costs associated with shareholders’ trading activity, and “is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be an additional tool to help funds manage liquidity risks,” the agency states. The SEC oversees registered investment companies with combined assets of approximately $18.8 trillion and RIAs with approximately $67 trillion in regulatory assets under management, White noted. At the end of 2014, 53.2 million households, or 43.3% of all U.S. households, owned mutual funds.  

Mutual funds and other open-end funds have grown to hold more than $15 trillion of investor assets, White continued, adding that fund industry is now using more funds that rely on securities that tend to be less liquid, such as high-yield bond funds, emerging market equity and debt funds, and funds with alternative strategies.

Foreign bond and equity funds, for example, “have grown steadily from approximately 11% of total industry assets in 2000 to more than 17% in 2014,” White noted. In addition, the assets of funds with alternative strategies grew from approximately $365 million to $334 billion from 2005 to 2014.

“With such changes come new challenges,” White said. “These funds offer investors additional investment options, but they can also increase the complexity and potential risks of fund portfolios and operations.”

The proposal is out for a 90-day comment period.

SEC Commissioner Daniel Gallagher noted that the plan also includes a “scaled compliance period” for smaller funds. Gallagher will leave his post as a commissioner by Oct. 2.

“A scaled compliance period allows smaller funds a longer period to implement necessary changes to their systems and procedures,” Gallagher said. “I hope and expect that the Commission will continue to recognize the challenges faced by smaller funds in future investment company rulemakings.”

— Check out SEC Fines First Eagle, Affiliate $40 Million for Improperly Charging Shareholders on ThinkAdvisor.