The Securities and Exchange Commission— as it prepares to celebrate the 75th anniversary of the Investment Company Act and the Investment Advisers Act next week—has proposed a slate of rules intended to enhance effective liquidity risk management by mutual and exchange-traded funds.
“These proposals are intended to foster a rigorous and analytically sound approach to liquidity risk management, while also helping investors to better guage the ability of funds to fulfill redemption obligations,” Commissioner Luis Aguilar said.
A key feature of open-end funds is that they allow investors to redeem their shares daily. Funds must maintain sufficiently liquid assets in order to meet shareholder redemptions while also minimizing the impact of those redemptions on the fund’s remaining shareholders. Proposed rule 22e-4 would require them to have a liquidity risk management program. Elements of that program would include: classification of 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; assessment, periodic review, and management of a fund’s liquidity risk; and establishment of a fund’s three-day liquid asset minimum.
A fund’s board, including a majority of the fund’s independent directors, would approve the fund’s liquidity risk management program and be responsible for reviewing a written, annual report on the program’s adequacy by the fund’s investment adviser or officer administering the program.
The Commission also proposed amendments to Investment Company Act rule 22c-1 to permit, but not require, open-end funds (except money market funds and ETFs) to use “swing pricing,” the process of reflecting costs associated with shareholders’ trading activity in a fund’s net asset value. It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks. The fund’s board, including independent directors, would be required to approve swing pricing policies and procedures.
The proposal also requires funds to classify, and periodically review, each of the assets in their portfolio and classify each asset position (or portion of a position) into one of six liquidity categories based on the number of days required to be convertible to cash: one business day; 2-3 business days; 4-7 calendar days; 8-15 calendar days; 16-30 calendar days; and more than 30 calendar days.
Funds would be required to determine a minimum percentage of net assets that must be invested in cash and assets that are convertible to cash within three business days at a price that does not materially affect the value of the assets immediately prior to sale.
Proposed amendments to the registration form used by open-end investment companies (Form N-1A) would require funds to disclose swing pricing and the methods used by funds to meet redemptions. Form N-PORT would be amended to require a fund to report the liquidity classification of each of the fund’s assets and proposed amendments to Form N-CEN would require funds to disclose information regarding committed lines of credit, inter-fund borrowing and lending, and swing pricing.
A 90-day public comment period will commence once the proposals are published in the Federal Register for.
While supportive of the proposed rules in general, Commissioner Michael Piwowar expressed concern with the rule’s three-day liquid asset minimum requirement.He would prefer to see the rule track to the Investment Company Act’s established seven-day liquid asset minimum.
Piwowar was hopeful the public comment period would address the swing pricing option because “there are other means by which a fund could mitigate dilution and ensure that redeeming shareholders bear the bulk of the costs associated with their redemptions.” For example, funds could use liquidity or redemption fees to serve a similar purpose without affecting the fund’s NAV.
Commissioner Daniel M. Gallagher, speaking at what will likely be his last open meeting before stepping down, called the proposals “an excellent example of a Commission initiative that focuses on [the Commission’s] core responsibilities” and “basic blocking and tackling.” He did, however, have “reservations” about the “functional value” of a three-day liquid asset minimum and the ultimate effectiveness of swing pricing.
“Mandating that funds have a liquidity risk management plan is sensible and long overdue,” Commissioner Kara Stein said. Her concern, however, was that the proposal may “not go far enough in certain areas.”
“We have seen a steady increase in the number of open-end funds pursuing more complex strategies focused on alternative investments and fixed income,” she said. “This has led to portfolio composition in mutual funds and ETFs that is far less liquid and more complex than what was ever envisioned under the Investment Company Act. This proposal presents an opportunity to better understand such developments and reassess our regulatory framework for these types of funds.”