A Major Rule Change for Mutual Funds and ETFs
Thursday, October 8, 2015

For the first time in 20 years, the Securities and Exchange Commission (SEC) wants to revise the rules governing how mutual fund and exchange-traded funds (ETFs) construct their portfolios. The proposal would set new rules on liquidity of a fund’s assets, enact swing pricing on mutual fund shares (which I’ll explain momentarily) and establish new reporting requirements. They could potentially be a positive for individual investors, while altering how some funds invest. As is always the case with big rule changes, there is also the potential for unintended consequences. (The entire proposal is on the SEC’s website.)

The proposed rules focus on the liquidity of a fund’s assets. Liquidity, in terms of investing, is how quickly an asset can be converted into cash at prevailing quoted prices. Highly liquid assets can be sold immediately without impacting the market price. Low-liquidity assets are very difficult to sell in a short period of time without impacting the share price. (Buyers demand a lower price when the number of securities for sale exceeds typical levels.)

Funds (both mutual funds and ETFs) would be required to categorize each of their portfolio positions into one of six categories based on how quickly they can be converted into cash: one business day, two to three business days, four to seven business days, eight to 15 business days, 16 to 30 business days or more than 30 business days. A set minimum portion of net assets would have to be allocated to securities the fund believes can be converted into cash within three business days without the transaction(s) altering the price of the securities. Funds would also be limited to allocating no more than 15% of their net assets to “15% Standard Assets.” These are assets that could not be sold over a course of seven days at the approximate value ascribed to it by the fund (or, in layman’s terms, at fire sale prices).

The intent is to ensure funds have the ability to quickly fulfill redemptions and easily handle inflows (meaning deposits) from shareholders. This is a good thing because if you want to sell shares of your fund, you should receive the cash quickly. At the same time, if you want to continue holding onto shares of the fund, the value of your investment should not be adversely impacted by the actions of another shareholder of the same fund. The proposed rule could alter the strategies of some funds (such as the alternative funds the industry has been aggressively promoting over the past few years) and create big headaches for others. (Dave Nadig, the director of exchange-traded funds for FactSet, cited domestic junk bond and bank note funds as examples.) It’s also possible that we could see a relative increase in the number of mutual funds closing to new investors in less liquid areas of the market such as micro-cap stocks.

To that end, SEC wants to implement swing pricing. Already used in certain European countries, swing pricing adjusts the share price for large inflows and redemptions. Under the proposed SEC rules, a mutual fund (but not an ETF), would be able to adjust its net asset value by a “swing factor” once the level of net redemptions or net purchases exceeds a certain percentage level. This passes along the costs resulting from a large shareholder purchase or sell order to the actual shareholder who placed the large order, mitigating the impact on all other shareholders. Most individual investors should not incur swing prices on their fund transactions, with the possible exception of those who have very high levels of wealth.

ETFs are excluded from the swing pricing rules because of their different structure. Mutual fund shares are bought and sold directly from the fund. ETF shares trade on the open market between shareholders. Only large institutional investors transact directly with ETF providers, exchanging large blocks of shares (known as creation units) for cash or the underlying assets.

As long I’m discussing exclusions, the proposed SEC rules do not apply to money market funds, closed-end funds or unit investment trusts (UITs).

The proposed rules further require mutual funds and ETFs to report information about the liquidity of their portfolio investments monthly, with up to a 30-day lag. Though actual portfolio holdings for mutual funds would still only have to be released quarterly, Nadig thinks institutional investors will place “significant pressure” to get the mutual fund holdings released on a monthly basis instead.

There’s a lot here, because it’s a major rule. The SEC is looking for public comments and if you have an opinion—whether positive or negative—I encourage you to go to the regulator’s website and give feedback.

Buying Stock Certificates

With the holidays coming around the corner, I wanted to add a quick note about gifting a share of stock. Last night, I noticed that the website OneShare.com was no longer up. From what I can tell, the company, which specialized in selling single-share stock certificates of publicly traded companies, is now out of business.

There are two other alternatives: UniqueStockGift.com and GiveAShare.com. I have not done business with either company. What I can tell you from my previous experience with OneShare is that getting an actual stock certificate in the mail takes several weeks, so if you’re looking to buy a holiday gift, I’d place your order soon.

More on AAII.com

The Week Ahead

The U.S. financial markets will be open on Monday, but the bond market and banks will be closed in observance of Columbus Day.

2015 tax returns are due on Thursday for those who previously filed an extension.

Many of the largest companies will report earnings next week. Among the nearly 40 S&P 500 companies on the calendar are Dow Jones industrial average components Intel Corp. (INTC), JPMorgan Chase & Co. (JPM) and Johnson & Johnson (JNJ) on Tuesday; Goldman Sachs Group (GS) and UnitedHealth Group (UNH) on Thursday; and General Electric Company (GE) on Friday.

The first economic reports of note will not be released until Wednesday: the September Producer Price Index (PPI), September retail sales and August business inventories. The September Consumer Price Index (CPI) and the October Empire State manufacturing survey will be released on Thursday. Friday will feature September industrial production and capacity, the University of Michigan’s preliminary October consumer sentiment survey and the August Job Openings and Labor Turnover (JOLTS) Survey.

Four Federal Reserve officials will make public appearances: Chicago president Charles Evans and Governor Lael Brainard on Monday, St. Louis president James Bullard on Tuesday and New York president William Dudley on Thursday.

October options contracts will expire on Friday.

What’s Trending on AAII
  1. Finding Bargains Among Stocks With Falling Stock Prices

  2. How Interest Rate Changes Affect the Price of Bonds

  3. The Model Shadow Stock Portfolio’s Long-Term Performance

AAII Sentiment Survey

Individual investor optimism about the short-term direction of stock prices is at its highest level in more than six months, according to the latest AAII Sentiment Survey. Neutral sentiment also rose, while pessimism plunged.

Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 9.4 percentage points to 37.5%. This is the highest level of optimism recorded by our survey since March 26, 2015 (38.4%). The rise was not large enough, however, to prevent bullish sentiment from staying below its historical average of 39.0% for a record 31st consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.3 percentage points to 34.3%. The increase keeps neutral sentiment above its historical average of 31.0% for the fourth consecutive week and the 37th week this year.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 11.7 percentage points to 28.2%. Pessimism was last lower on July 23, 2015 (25.6%). The historical average is 30.0%.

The big rebound in bullish sentiment occurred as stocks rebounded from their late-September lows. It also follows last week’s unusually low level of optimism. Bearish sentiment, on the other hand, pulled back from a reading that was near the top of its historical trend.

This week’s shift in sentiment likely reflects optimism on the part of some individual investors that a bottom in the market has been set. Sentiment among individual investors remains mixed, however, with some having bought on the dips and others having increased their cash positions. Impacting AAII members’ six-month outlook for stocks are global and international events (particularly China and global economic weakness), U.S. monetary policy, technical factors (seasonal trends, the recent correction or the chance of further price declines occurring), U.S. politics and the pace of U.S. economic growth.

This week’s special question asked AAII members how, if at all, they have recently adjusted their stock investing strategy. Three out of 10 respondents (30%) said they have not made any change. Many said that they are following long-term strategies, while others said they intend to ride out the current volatility. About 16% said that they reduced their stock holdings and are now holding more cash. Nearly 15% favor dividend-paying stocks, while 14% are favoring value, 6% are seeking growth and 5% said large-cap stocks (without giving a preference for value or growth). Some respondents listed more than one style or asset class.

Here is a sampling of the responses:

  • “With increased volatility, I feel that searching for value is best for long-term growth.”
  • “I have increased some positions in large-cap stocks that I feel were sold off to unreasonably low levels.”
  • “I have not changed my strategy as I am a long-term investor.”
  • “I have sold most of our equities as a result of stop-loss orders.”
  • “I won’t be buying any stocks until I see more clarity in the market.”
  • “Looking for more large-cap dividend-paying stocks. I believe they will be less volatile.”

This week’s Sentiment Survey results:

Bullish: 37.5%, up 9.4 points
Neutral: 34.3%, up 2.3 points
Bearish: 28.2%, down 11.7 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!