The SEC wants to make sure mutual funds and ETFs are liquid for investors. This isn’t going to be as simple as it sounds.

The SEC has proposed rules to insure liquidity at mutual funds and exchange traded funds (ETFs). This all sounds good, but making it work will be another matter. The press release, dated September 22nd is entitled “SEC Proposes Liquidity Management Rules For Mutual Funds And ETFs”. There will be a comment period that begins after the proposed rules (22e-4) are published in the Federal Register.

Broadly speaking, the SEC wants:

“…A fund’s liquidity risk management program would be required to contain multiple elements, including: classification of the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact; assessment, periodic review and management of a fund’s liquidity risk; establishment of a fund’s three-day liquid asset minimum; and board approval and review. In addition, the proposal would codify the 15 percent limit on illiquid assets included in current Commission guidelines…”

Liquidity, according to the press release, is defined as “…the risk that a fund could not meet redemption requests that are expected under normal conditions or under stressed conditions, without materially affecting the fund’s net asset value (NAV) per share…”

From the press release, “…The classification would be based on the number of days in which the fund’s position would be convertible to cash at a price that does not materially affect the value of that asset immediately prior to sale.  Proposed rule 22e-4 would include factors that a fund would be required to take into account when classifying the liquidity of each portfolio position…” They will divide assets into buckets based on how long it will take to convert it into cash (1 day, 2-3, 4-7, 8-15, 16-30, 30 days plus).

We think back to the memo written by Oaktree’s Howard Marks to their clients  simply called “Liquidity”, We wrote about this in our April 7, 2015 post “ETF liquidity: will it be illusory in volatile markets?” and said:

“…Marks writes that an asset might be liquid if you want to buy when everyone is selling, but if you are the seller you might have a different point of view. The answer to the question “is there liquidity” has different answers depending on the state of the market and what you are trying to do. If a market looks liquid now, will it stay that way? Often investors make decisions based on the liquidity at that moment in time, extrapolating it out to an anticipated holding period. Liquidity can tempt investors to mimic traders, thinking only in the short term. Nasty surprises can follow…”

So if liquidity is a function of the market at the time and if you are buying or selling, we wonder how funds can characterize each position’s liquidity using a metric of how many days it will take to sell without moving the price? Will they look at historical market volumes? Will it differentiate liquidity in a rising  versus falling market? They will benchmark off of stressed markets (think: August 24, 2015 or October 15, 2014) and using that worse-case scenario we wonder if anything will look liquid?

We suspect that the optics of reporting these numbers — whether accurate or not — may shift funds to what they suspect are more stable investments.

The SEC referred to a white paper “Liquidity and Flows of U.S. Mutual Funds” where they observed that the average fund typically sell liquid assets when faced with large redemptions rather than a strip of the entire fund. This is no surprise — investors needing to raise cash will sell what they can. But it leaves the remaining investors stuck with the illiquid stuff. To deal with this, the SEC is proposing “swing pricing”. Funds would be allowed, but not required, to adopt this mechanism. ETFs and money markets funds won’t be included in swing pricing.

“…Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders.  It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks…”

and

“…A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV known as the swing threshold.  The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold.  The fund’s board, including the independent directors, would be required to approve the fund’s swing pricing policies and procedures…”

So if swing pricing had kicked in, would any seller/buyer of the fund end up with a lower/higher price (than the market) on what they transacted? Won’t it add to volatility as investors try to jump ahead of the swing price triggering? We think back to the NY Fed’s Liberty Street Economics August 18, 2014 post “Gates, Fees, and Preemptive Runs” where they suggested that preemptive runs might occur when funds are subject to gates or charge redemption fees. Their beef was with the SEC and potential rules impacting money market funds. We wrote about it in a August 27, 2014 post “The Fed’s Liberty Street Economics gets it right on gating and fees to prevent runs: they don’t work”.

Swing pricing also sounds like a second set of prices that reflect the impact of illiquidity. Letting that genie out of its bottle could impact markets well beyond those the SEC are targeting.