What can past market crashes teach us about the current one?
The markets have largely recovered since the March selloff, but most would agree we're not out of the woods yet. The COVID-19 pandemic isn't close to being over, so it seems that volatility is here to stay, at least until the pandemic becomes less severe. Q2 2020 hedge fund letters, conferences and more At the Read More
I’m still working through the SEC’s proposal on Mutual Fund Liquidity, which I mentioned at the end of this article:
Q: Are you going to write anything regarding the SEC’s proposal on open end mutual funds and ETFs regarding liquidity?
A: …my main question to myself is whether I have enough time to do it justice. There’s their white paper on liquidity and mutual funds. The proposed rule is a monster at 415 pages, and I may have better things to do. If I do anything with it, you’ll see it here first.
These are just notes on the Mutual Fund Liquidity proposal so far. Here goes:
1) It’s a solution in search of a problem.
After the financial crisis, regulators got one message strongly — focus on liquidity. Good point with respect to banks and other depositary financials, useless with respect to everything else. Insurers and asset managers pose no systemic risk, unless like AIG they have a derivatives counterparty. Even money market funds weren’t that big of a problem — halt withdrawals for a short amount of time, and hand out losses to withdrawing unitholders.
The problem the SEC is trying to deal with seems to be that in a crisis, mutual fund holders who do not sell lose value from those who are selling because the Net Asset Value at the end of the day does not go low enough. In the short run, mutual fund managers tend to sell liquid assets when redemptions are spiking; the prices of illiquid assets don’t move as much as they should, and so the NAV is artificially high post-redemptions, until the prices of illiquid assets adjust.
The proposal allows for “swing pricing.” From the SEC release:
The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use “swing pricing.”
Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders. 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. Pooled investment vehicles in certain foreign jurisdictions currently use forms of swing pricing.
A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV known as the swing threshold. The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold. The fund’s board, including the independent directors, would be required to approve the fund’s swing pricing policies and procedures.
But there are simpler ways to do this. In the wake of the mutual fund timing scandal, mutual funds were allowed to estimate the NAV to reflect the underlying value of assets that don’t adjust rapidly. This just needs to be followed more aggressively in a crisis, and peg the NAV lower than they otherwise would, for the sake of those that hold on.
Perhaps better still would be provisions where exit loads are paid back to the funds, not the fund companies. Those are frequently used for funds where the underlying assets are less liquid. Those would more than compensate for any losses.
2) This disproportionately affects fixed income funds. One size does not fit all here. Fixed income funds already use matrix pricing extensively — the NAV is always an estimate because not only do the grand majority of fixed income instruments not trade each day, most of them do not have anyone publicly posting a bid or ask.
In order to get a decent yield, you have to accept some amount of lesser liquidity. Do you want to force bond managers to start buying instruments that are nominally more liquid, but carry more risk of loss? Dividend-paying common stocks are more liquid than bonds, but it is far easier to lose money in stocks than in bonds.
Liquidity risk in bonds is important, but it is not the only risk that managers face. it should not be made a high priority relative to credit or interest rate risks.
3) One could argue that every order affects market pricing — nothing is truly liquid. The calculations behind the analyses will be fraught with unprovable assumptions, and merely replace a known risk with an unknown risk.
4) Liquidity is not as constant as you might imagine. Raising your bid to buy, or lowering your ask to sell are normal activities. Particularly with illiquid stocks and bonds, volume only picks up when someone arrives wanting to buy or sell, and then the rest of the holders and potential holders react to what he wants to do. It is very easy to underestimate the amount of potential liquidity in a given asset. As with any asset, it comes at a cost.
I spent a lot of time trading illiquid bonds. If I liked the creditworthiness, during times of market stress, I would buy bonds that others wanted to get rid of. What surprised me was how easy it was to source the bonds and sell the bonds if you weren’t in a hurry. Just be diffident, say you want to pick up or pose one or two million of par value in the right context, say it to the right broker who knows the bond, and you can begin the negotiation. I actually found it to be a lot of fun, and it made good money for my insurance client.
5) It affects good things about mutual funds. Really, this regulation should have to go through a benefit-cost analysis to show that it does more good than harm. Illiquid assets, properly chosen, can add significant value. As Jason Zweig of the Wall Street Journal said:
The bad news is that the new regulations might well make most fund managers even more chicken-hearted than they already are — and a rare few into bigger risk-takers than ever.
You want to kill off active managers, or make them even more index-like? This proposal will help do that.
6) Do you want funds to limit their size to comply with the rules, while the fund firm rolls out “clone” fund 2, 3, 4, 5, etc?
Mutual Fund Liquidity Summary
You will never fully get rid of pricing issues with mutual funds, but the problems are largely self-correcting, and they are not systemic. It would be better if the SEC just withdrew these proposed rules. My guess is that the costs outweigh the benefits, and by a wide margin.