The fed-up responses from trustees, who represented fund complexes ranging in size from the $3.64trn Fidelity Funds to the $81m Datum One Series Trust, signaled a rupture in the already tense relationship between the industry and its regulator.
Most called for the SEC to withdraw the ambitious proposal, which would require all mutual funds to adopt the complex swing pricing mechanism and implement a “hard close” when processing customer transactions.
Many argued that requiring swing pricing in the name of liquidity would burden fund complexes and harm mutual fund investors without solving the problems the SEC aimed to fix.
In a sign of industry solidarity, many boards’ comments also endorsed and echoed letters from industry groups like the Investment Company Institute (ICI), the Independent Directors Council (IDC), and the Mutual Fund Directors Forum (MFDF).
The overall volume of responses to the swing-pricing rule did not approach the thousands of comments submitted against recent proposals requiring disclosure of climate-change risk and other regulations that would affect any registered public company. However, the number of comments posted by fund-board representatives soared far beyond the level of comment typical of any regulation specific to investment advisory firms.
Even the 2020 valuation rule proposal, one of the most talked-about in recent fund-governance history, inspired comment from only five boards. The 2015 liquidity rule proposal generated only one fund-board comment. No fund boards commented in response to the 2015 derivatives rule. The 2013 money market reform proposal inspired only four responses.
This time, however, several of the most prominent boards – including those representing the J.P. Morgan Funds, the PGIM Retail Funds, the SEI Trusts, the AllianceBernstein Funds, the Calamos Funds, and the Datum One Series Trust – said that a sense of urgency about the issue had driven them to comment for the very first time.
“For us, writing a comment letter is unprecedented. We have historically relied on the Commission’s pulse on the industry, as well as its open communication with the very entities it regulates, in accepting new or revised regulatory requirements as reasonable,” wrote the board of the Calamos Funds. “This Proposal, however, seems to reflect neither an understanding of the industry nor industry input. We are gravely concerned about our investors.”
A clear verdict on swing pricing
The proposal aims to address what the SEC views as underlying structural liquidity issues that emerged in March 2020, when some fund investors pulled their money due to fears about the economic impact of the Covid-19 pandemic.
It would require all mutual funds to implement swing pricing, a mechanism designed to discourage panic-selling and prevent the dilution of shareholders who don’t sell. When redemptions are high, a fund can “swing” its net asset value (NAV) higher to offset transaction costs incurred by having to sell assets quickly to satisfy redemption demands, thus ensuring that redeeming shareholders are the ones bearing the costs.
Many European mutual funds use swing pricing, but no U.S.-based mutual fund ever has despite having permission to do so since 2016.
In their comments, fund boards offer a unified theory of why the industry has rejected swing pricing: We don’t need it.
The vast majority of commenters testified that current tools for managing liquidity, including the liquidity rule, had served them well, even during the turmoil of 2020.
“Our experience to date is that the liquidity risk management program has functioned as intended, and the Funds have in the past and continue to be able to meet requests for redemption without dilution of remaining investors’ interests in the Funds,” wrote the board of the Northern Funds.
“We have a responsibility to serve the best interests of Trust investors, who have not, in our experience, expressed concern that Fund redemptions could have a dilutive effect on their interests in the Funds or suggested that the Board should consider adopting a swing pricing program under existing SEC rules,” wrote the board of the SEI Trusts.
In light of the satisfactory performance of current liquidity tools, swing pricing could only be an expensive solution in search of a problem, according to commenters.
Many also protested that swing pricing was antithetical to the U.S. mutual fund structure because it injected randomness into NAVs that were supposed to be logical and transparent.
“This would erode a defining characteristic of all mutual funds: predictability in how the NAV is calculated,” wrote the board of the Prudential Insurance Funds. “That calculation has been sacrosanct because it is well-understood and ensures that all investors are treated equally. The Proposal exposes today’s NAV calculation to the mercurial nature of asset flows, creating illogical and unfair results.”
For smaller funds, commenters warned swing pricing could allow a single large transaction to swing the NAV for a whole day, exposing any other investors who transacted that day to an unforeseen fluctuation in their share price.
“The Proposals would disadvantage smaller/retail shareholders that are redeeming the same day as large investors,” wrote the board of the Lord Abbett Funds.
A hard “no” to the hard close
As adamant as they were against swing pricing, commenters may have been even more adamant against the proposed “hard close” that would facilitate it.
Whereas swing pricing requires fund managers to be aware of the entire day’s orders before calculating their NAV, U.S. funds calculate their daily NAV at a “soft” closing time of 4pm ET but allow orders placed with intermediaries before 4pm to transact at that price until the following morning.
Therefore, to make swing pricing possible, the SEC’s proposal mandates a “hard close,” requiring funds to have received a customer order by 4pm ET for the customer to qualify for that day’s NAV.
The hard close became one of the biggest points of concern among board comments, which argued that it would create an unfair playing field by forcing investors who hold fund shares through intermediaries to place their orders earlier than investors who buy shares directly from the fund.
“If the hard close requirement is adopted, shareholders transacting through intermediaries will be forced to make transaction decisions hours before their direct shareholder counterparts,” wrote the J.P. Morgan Funds board.
“This in effect would create disparate classes of investors, depending on their particular intermediary’s requirements or if they hold their shares directly, in turn creating disparate investment opportunities for our shareholders,” wrote the Principal Funds board.
Several commenters articulated a fear that, rather than incentivize fund intermediaries to develop new systems for processing orders, the hard close could cause intermediaries to drop mutual funds from their offerings in favor of less-regulated investment vehicles, like collective investment trusts (CITs).
“It is reasonably foreseeable, for example, that collective investment trusts (‘CITs’) could replace mutual funds on many platforms, as CITs are not subject to the 1940 Act and would not be subject to the hard close requirement,” wrote the board of the State Street Funds. “If this happens, the Proposal will effectively promote the use of CITs or other types of investment vehicles over mutual funds for retirement and other intermediated accounts, where investors have fewer options and less protection.”
Disbelief at the lack of data
Even as they launched volleys of objections at the substance of the rule, boards reserved their most emotional barbs for the SEC itself, evincing a shared perception that regulators had been less than careful when crafting a proposal that could reshape the industry.
Much of the anger centered on a footnote in which the SEC — after having justified the far-reaching proposal by citing market turmoil early in the pandemic that exposed “weaknesses” in fund liquidity risk management — admits, “We do not have specific data about the dilution fund shareholders experienced in Mar. 2020.”
Some commenters expressed disbelief at this admission; others contrasted it with the careful preparation that trustees must show for each of their decisions.
“We are also deeply concerned that such substantial changes have been proposed without first collecting and analyzing the necessary data that demonstrates that a problem exists and is of a magnitude sufficient to justify the costs associated with the Proposal,” wrote the Fidelity boards.
“Regulatory action must engage in no less rigorous a cost-benefit analysis than we have to undertake as Independent Directors,” wrote the board of the Prudential Insurance Funds. “We could ill afford to embark on any initiative, or to otherwise seek to fulfill our fiduciary obligations as Independent Directors, without trying to understand the potential costs to our shareholders.”
In its comment letter, the ICI criticized the proposal’s lack of data and offered an analysis of its own members’ fund data in March 2020, arguing that liquidity fears played little to no role in fund investors’ panic-selling, even among the most stressed asset classes.
“For example, for high-yield bond funds, the highest day of estimated dilution in March 2020 might be about 5 basis points (depending on the model used), but high-yield returns on average varied daily by 150 basis points that month,” it wrote. “In other words, daily returns varied 25 to 150 times more that the dilution estimates, suggesting that fund investors —like all other investors, whether in pooled products or not—were likely focusing on overall market conditions, not any potential dilution.”
That footnote was not the only cause for outrage boards found in the proposal. In a section that would normally include an analysis of the expected costs of implementation, the SEC wrote that it could not accurately estimate the costs of a swing pricing implementation, in part because “we cannot predict the number of investors that would choose to keep their investments in the mutual fund sector nor the number of investors that would exit mutual funds and instead invest in other fund structures such as ETFs, closed-end funds, or CITs.”
This reasoning, with its acknowledgement that mutual funds could lose market share to non-registered CITs without independent board oversight, did not sit well with trustees, either.
“Is the Commission really putting forth potential reforms that would drive investors out of the type of product that is regulated precisely to protect them?” wrote the board of the PGIM Retail Funds.
“We are absolutely befuddled by the notion that our industry’s principal regulator would issue any proposal that could result in investors flocking to less regulated products,” wrote the board of the Prudential Insurance Funds. “It is counterintuitive.”