Swing pricing is coming to the U.S. and the response has been a mixed bag.
Discussions around swing pricing started in earnest September 2015, when the Securities and Exchange Commission (SEC) published a proposal for reforms “designed to enhance effective liquidity risk management by open-end funds.”
About a year later, in October 2016, the SEC adopted amendments to rule 22c-1 under the Investment Company Act that permits (but does not require) mutual funds to use swing pricing as an anti-dilution mechanism. That means registered open-end management investment companies (except money market funds and exchange-traded funds), under certain circumstances, will be able to use swing pricing to minimize the effect of trading activity on long-term fund investors by adjusting a fund’s net asset value (NAV) to reflect trading costs associated with subscriptions and redemptions. Funds can then pass on the associated trading costs to the purchasing and redeeming shareholders.
But there are a few things firms will need to do to be able to use this mechanism. In order to adjust their NAV accordingly with daily activity, funds will need to establish a predetermined net capital activity threshold, called a swing threshold, as well as an adjustment factor, called swing factor, which is usually expressed as a percentage of the NAV. The level of subscriptions and redemptions that would trigger the application of a swing factor to the NAV will also need to be documented in a board approved policy and reviewed at least annually by the fund’s board. Funds will also need to update the purchase and redemption information in their prospectus prior to using swing pricing, and once in use funds will need to make additional on-going disclosures to investors and regulators.
In Europe, swing pricing has proven to be an effective method to protect the interests of long-term investors and is widely used. In the U.S., however, it is raising some concerns.
In practice, existing shareholders will not know when the NAV per share has been swung. No disclosure will be made as to whether the NAV for the day is swung or unswung. The published NAV may include a swing-price adjustment, which could distort the calculation of performance. And if attribution is based on investment accounting data, there might be discrepancies between the official relative return and the total effect.
In Luxembourg, for example, the home of swing pricing for 20 years, more than 50 percent of funds applied swing pricing in 2015 and surveys conducted by the Association of the Luxembourg Fund Industry (ALFI) show that adoption of the technique increases each year.
But in the U.S., there is a possibility that some firms might shy away from swing pricing because of its operational and technical implications.
First of all, the use of swing pricing will slightly differ in the U.S. than in Europe because of market cut-off times. In Europe, order cut off is generally around noon so intermediaries have time to submit transactions before the fund calculates its daily NAV. In the U.S., that happens at 4 pm. Funds will therefore have to rely on estimates to determine their daily flows.
There is also concern around capital activity in the U.S., which is driven by intermediaries, especially 401k administrators, who typically finalize and communicate capital activity in an overnight batch. To make swing pricing viable in practice, capital activity – or at least a good estimate of capital activity – will need to be delivered with enough lead time to be used to calculate the NAV per share at 6:00 PM, just two hours after the capital activity cut off. There is nothing in the rule amendment to compel the intermediaries to provide the information any earlier.
Because of the need for timely capital activity information from intermediaries, it is important to do back testing in preparation early on in the process. This will help firms determine whether swing pricing is possible with current delivery of capital activity, or if the fund will need to work to get an earlier delivery before swing pricing becomes viable.
For global asset managers who have funds domiciled in both Europe and the U.S., swing pricing may end up having more appeal. But in a survey Confluence conducted during our latest webinar on swing pricing, 69 percent of respondents said they have not yet decided whether they will use swing-pricing for ‘40 Act Funds.
But even if it takes years before we see domestic funds adopt swing pricing in the U.S., it is still prudent to understand the implications (and the potential benefits) now, so that educated decisions can be made and the necessary preparations put in place.