David Weibe, Senior Vice President, Fund Accounting at Brown Brothers Harriman discusses the two key challenges US mutual funds face in implementing swing pricing.
A key part of the SEC’s sweeping liquidity risk proposals is permitting the activity of swing pricing across mutual fund portfolios. This may appear to be the least ambiguous part of the liquidity proposals, but it is perhaps the most difficult aspect for US funds to implement. As a refresher, swing pricing is a means to preventing significant dilution to existing investors by allocating the impact of trading costs to only those trading in or out of the fund. The cost that those investors pay is called the swing factor and is a direct addition or subtraction to the dealing NAV per share in which they transact upon.
Swing pricing has proven to be an effective method to protect the interests of long-term investors. For some years now, the European fund community has successfully adopted swing pricing. In the US, however, there are a number of unique challenges compared to Europe. The two biggest hurdles: information timing and policy supervision.
Timing is Everything
Timing of information flows tops the list of challenges. In the US, subscription and redemption orders must be placed by 4:00 PM EST in order to transact at that day’s NAV. This coincides with the valuation point of most US mutual funds, with a typical NAV delivery taking place at 6:05 PM EST per traditional NASDAQ print deadlines.
Transfer agents may be able to solve the relatively mild challenge of receiving and aggregating flows from financial intermediaries after 4:00PM EST, but the overarching showstopper is the potential for deal information to be incomplete. This is because flows making their way through trade processing and settlement platforms may not be available until after the NAV is struck. In others words, US intermediary systems commonly require a NAV prior to calculating and reporting a transaction, preventing that information from being available earlier. Any type of batch reporting or overnight processing that is in place with the intermediary policies only exacerbates the issue given the likely high cost of system redesign to support estimates or intraday flows. In addition, US fund flows are generally higher-volume and lower-value than in Europe where institutional aggregators bulk trades– rather than the diverse broker-dealer networks – and administrating of these volumes in a tighter window makes swing pricing very challenging and complex.
So what does that mean? It means that where all flow information is not readily available, there is a much higher probability of swinging a NAV incorrectly. The impacts of incorrect swing pricing should not be underestimated. For example, information delivered at 4:00 PM EST may indicate net inflows for the day. As a result, the fund may swing the NAV upwards by, let’s say, a swing factor of 50 basis points. Fast forward three hours and new information may come in to indicate that due to missing redemption orders, the NAV should have swung downwards by 50 basis points given net outflows. That net 100 basis point difference not only constitutes a material error by SEC standards, but also gives redeeming investors an advantage while leaving remaining shareholders left to cover trade costs and then some.
Swing Policy Supervision
The second major challenge that US asset managers face is implementation and maintenance of comprehensive swing pricing policies.
The easiest decision is whether a fund will swing on a full or partial basis. A full swing is the application of a swing factor to the dealing NAV when there is any investor trading. In contrast, a partial swing requires that a certain dollar or percentage of AUM figure is exceeded in order to affect the NAV. As a result, it is likely that an open-ended mutual fund would swing on a partial basis only when a particular trading threshold is exceeded.
Determining the swing factor is not as straightforward. The purpose of the factor is to represent an accurate cost of trading, which could include numerous factors such as liquidity considerations, broker spreads, and, in some cases, taxes. As markets shift, there is a need to have a robust governance and oversight structure in place to ensure that the fund remains fair to investors in all dealing periods. Many managers with EU based funds have worked through this learning curve in terms of which products are appropriate to apply a swing to and how often they update their policies but it will be new to many US managers. The process may also include stakeholders not directly involved in the portfolio management decision-making process such as Fund Treasury groups and members of each fund’s Board of Directors. In many cases, these individuals may need education on the technical background necessary to oversee the performance of the required due diligence. This knowledge gap would need to be funded by either additional staff with technical backgrounds or by taking front office staff away from their core duties of portfolio management. None of these challenges are insurmountable for US managers but will come with certain growing pains if adopted.
What about Europe?
Given all the challenges swing pricing presents in the US, it’s fair to ask “Why is it so popular in Europe?”
First, swing pricing works in Europe because cutoff times for investor orders are generally staggered at earlier times and there is more flexibility around trade cutoff and NAV publication times. This provides transfer agents with greater ability to collate complete information, which in turn, leads to greater accuracy in swinging a NAV. Also, the European fund market generally relies less on direct retail flows through broker dealers and is conducted more through bulk orders from institutions, which is helpful for timing and completeness as data can be aggregated more quickly from fewer orders. As a result, there is greater certainty around investor flows for the day, leading to a high degree of confidence in the decision to apply a swing factor to the NAV.
Secondly, swing pricing has existed in Europe for a number of years, so European asset managers and their regulators have mostly worked out the kinks in the process. While determining the swing factor is not a ‘set and forget’ exercise, there is also some understanding that it can’t be something that is changed frequently anytime there is a market event. Ensuring that the policy is not over-engineered makes the process easy to understand and approve at the management company or board level, and makes it more defensible to clients, regulators, and auditors.
Until industry and regulators in the US address these systemic challenges, the adoption of swing pricing is likely to be low. Also, since the swing pricing measures are voluntary they have undoubtedly taken a backseat to other SEC priorities and challenges such as intraday pricing, asset liquidity categorization, and affiliated reporting requirements. That said, the heavier points of emphasis from the industry have been focused on the unique timing aspects in the US as well as on fundamental changes that would be required by intermediaries to appropriately support swing pricing.