A nightmare scenario has haunted asset managers for years: What if the flood of cash that's poured into debt mutual funds since 2008 suddenly reverses, leaving a field of financial-market carnage behind?
The likelihood of such an outcome is being debated vigorously, but that hasn't stopped the Securities and Exchange Commission from taking preventive measures to mitigate any potential damage. Regulators last week approved new liquidity rules for mutual funds, including a provision to allow money managers to impose something called swing pricing, or charging clients more to withdraw significant amounts of cash during times of stress. Think of it as surge pricing for antsy investors.
In theory, this should prevent mutual-fund investors from racing to the exits all at once at the first sign of trouble and forcing funds into a fire sale of underlying assets. In reality, it's hard to see how this rule will eliminate the risk in an extreme downturn. In essence, the main benefit will be to reward investors who buy mutual fund shares and hang onto them while penalizing those with itchy trigger fingers. (Extra fees rarely hurt for asset managers, either.)
The idea of swing pricing isn’t a new concept and has become increasingly common in Europe. About two out of three asset managers in Luxembourg, Europe's biggest fund domicile, now employ this measure. The goal is to protect loyal investors from outsize losses in rapidly deteriorating markets and charge new investors more to help offset the rising cost of purchasing securities when asset prices are rallying.
The introduction of such a policy in the U.S. raises a few important questions. First, how will each firm determine how much clients are charged at any given time? Second, at what point will these fees essentially function as a gate, blocking investors from leaving the fund and compromising the asset manager's reputation?
Determining the cost of trading, especially in less-liquid asset classes, is as much an art as a science. Some investment firms have taken pains to establish concrete rules, with JPMorgan Asset Management saying it determines swing pricing in "a clear and systematic fashion," according to an August statement discussing the firm's funds domiciled in Luxembourg. It has a "swing pricing committee" that typically meets quarterly to "ensure the appropriate level of protection," according to an August statement.
Then, there's the issue of whether an extra fee will prevent investors from withdrawing their cash if they truly believe the market is collapsing. The answer is probably not. In fact, if a fund manager decides to charge a substantially bigger fee than usual, that could even signal to investors that the market is headed for a serious downturn, making it a self-fulfilling prophecy.
It's worth taking a step back and examining the current environment. Investors have piled into highly rated bonds, accepting record-low yields on the heels of central bank stimulus. Now some are worried that central bankers have run out of ammunition. Meanwhile, investors have continued to flock to bond mutual funds because every time someone warns them that bonds are poised for their worst year ever, they post yet another near-record rally.
Swing pricing works for buy-and-hold investors who could be hurt by the trading costs incurred by fellow mutual-fund shareholders who buy into expensive markets and sell into cheap ones. But it's hard to see how it could halt a freight train bound for the exit if the selling gains momentum.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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