A Big Rule Change for Mutual Fund and ETF Portfolios

The Securities and Exchange Commission (SEC) proposed new rules regarding how mutual and exchange-traded funds (ETFs) construct their portfolios.

The rules establish liquidity standards for a fund’s assets, enact swing pricing on mutual fund shares and establish new reporting requirements. [The proposal does not apply to money market funds, closed-end funds or unit investment trusts (UITs).]

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 accepting a significantly lower price.

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 the assets can be converted into cash. A 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 altering the value 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 them by the fund. Mutual funds and ETFs will have to report information about the liquidity of their portfolio investments monthly.

The intent is to ensure funds have the ability to quickly fulfill redemptions and easily handle inflows (deposits) from shareholders. 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 SEC’s proposed rules, a mutual fund 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 would pass along the costs resulting from a large shareholder purchase or sell order to the actual shareholder making the transaction, mitigating the impact on all other shareholders. (ETFs are excluded from the swing pricing rules because of their different structure.)

As of press time, the SEC is seeking public comment on the proposal until January 13, 2016: www.sec.gov/rules/submitcomments.htm.

Source: “Open-End Fund Liquidity Risk Management Programs; Swing Pricing; Re-Opening of Comment Period for Investment Company Reporting Modernization Release,” SEC, September 22, 2015.