For the time being, COVID-19 casts its shadow over every aspect of global asset management. The pandemic has impacted asset management operations, fund flows, valuations, market liquidity, and everything in between. In such volatile and uncertain times, asset managers have been compelled to reach deep into their liquidity management toolboxes to manage increased investor redemption activity in an orderly manner.
Overall, the global funds market has been relatively resilient. There hasn’t been a raft of gating or redemption suspensions, even if the overall redemption and liquidity environment is undoubtedly challenging. Fund liquidity has been a central focus of global regulators for some time now, and cautiously we can suggest that to date overall funds have weathered the liquidity storm reasonably well. Where necessary, funds have utilized liquidity mechanisms such as extended redemption settlement dates or short-term borrowings, while others have deployed redemption fees or anti-dilution levies to curb the impacts of outflows. The primary question among many managers, however, has been:
How can we ensure that fund prices are fair for both investors staying in a fund and those leaving?
The answer for many asset managers has been swing pricing.
A swing pricing introduction
For those not so familiar with swing pricing, it is a practice by which transaction costs are passed to the incoming or outgoing shareholder. The concept is pretty simple: when a fund receives a net inflow, it must buy securities with those proceeds. And when a fund receives net redemptions, it must sell securities to fund those outflows. Both events result in the fund and its remaining investors bearing transaction costs. As such, swing pricing aims to offset these trading costs so that all investors are treated fairly. Consider this simple example.
- Fund A has a total net asset value of $1,000,000
- Fund A receives redemption order on a dealing day of $100,000 from a single investor
- Fund A must make security sales of $100,000 from the funds’ portfolio to generate the required cash to fund the investors’ redemption order
- These security transactions incur costs of $2,000
- Without swing pricing, these costs are borne directly by Fund A (or more correctly the remaining investors pay the trading costs incurred on behalf of the redeeming investor)
- With swing pricing, instead the transaction costs are taken from the redemption proceeds of the redeeming investor and they receive $98,000 instead of the full amount. The $2,000 is retained by Fund A to cover the security sales costs.
It also helps with the preservation of the fund’s performance track record, since it’s not eroded by the cost of redeeming investors. A fund that decides to “swing” will adjust its net asset value (NAV) by a pre-determined amount, known as the swing factor.
Swing pricing is not a new concept for funds, but it has certainly come under the industry spotlight in recent weeks as the ongoing pandemic continues to create considerable financial market volatility. Historically, swing pricing has been most used by cross border UCITS funds, but the practice is now being more deeply considered in other markets such as the United States, Germany, and the UK where fund liquidity pressures make its use more compelling.
Regulators remove restraints
The use of swing pricing has grown significantly in recent times, and it has led to increased interest among policymakers. In February, for the first time, the German parliament approved changes in its Capital Investment Act to allow domestic funds to use swing pricing to manage liquidity. The UK’s Financial Conduct Authority (FCA) has also chimed in on swing pricing recently following several recent fund liquidity events. Perhaps most notably, the Commission de Surveillance du Sector Financier (CSSF) in Luxembourg, and the Securities and Futures Commission (SFC) in Hong Kong, have issued updates with regards to the use of swing pricing in the context of COVID-19 volatility.
This recent regulatory forbearance allows funds to disregard self-imposed thresholds contained in existing policies and prospectuses temporarily. Both regulators state that funds may exceed disclosed swing pricing constraints beyond currently disclosed maximum levels, so long as they have a solid rationale to support this decision, they update their documentation as soon as practicable and subject to other conditions. Overall, this latitude has been welcomed by managers at a turbulent time in the markets. Several asset managers have used the additional flexibility to manage their fund liquidity.
To explain the relief granted in more detail, we must first recognize that there are three primary ways of applying swing pricing to funds:
The fund’s Net Asset Value (NAV) is adjusted up or down on every NAV calculation no matter the value of the net inflow/outflow. In effect, the fund swings up or down every time there is dealing to ensure all transaction costs are covered by the subscribing or redeeming investors rather than the fund.
A partial swing is probably the most frequently used method in the industry. In a partial swing, the fund’s NAV is not adjusted unless net inflows/outflows exceed a pre-determined threshold. If the threshold is exceeded, then the Net Asset Value (NAV) is adjusted up or down by an established percentage value or ‘factor’ usually defined by a threshold and disclosed in the funds’ prospectus.
This methodology sets a level of materiality which helps curb frequency of use, operational complexity, and fund price volatility.
A tiered swing represents the most sophisticated operational approach. In a tiered swing, the fund’s NAV is adjusted based on multiple pre-determined threshold and factors. Depending on a pre-defined inflow/outflow threshold being breached, the fund then applies varying factors to the funds. Funds may use different factors for subscriptions and redemptions, for example, or have differently tiered factors for equity funds or bonds funds.
The temporary relief allows funds to reduce the net flow thresholds (so they are swinging more often) and increasing the swing factor (so they are swinging to a greater degree capturing the prevailing trading cost premiums in illiquid markets). Amid highly volatile markets, most funds have been dealing with net redemption activity and selling securities to fund redemptions. As such, most NAVs have been swinging “down.” Historically, swing factors have been in the one percent to three percent range. However, the recent mixture of large net redemptions, volatile pricing, and market illiquidity has meant some funds are extending or at least considering extension beyond the three percent upper boundary.
What is certain is that fund liquidity toolboxes will remain open for the foreseeable future and swing pricing will likely be a valued tool among many. It goes without saying that COVID-19 has ushered in a new era of fund liquidity. The silver lining: the lessons we learn in this crisis can help us prepare for future fund liquidity situations.