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E-MailLuis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s recent public statement at an open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.
The fund industry has witnessed substantial changes in recent years, including the rise of novel investment strategies, a growing use of derivatives, and an increased focus on assets that, traditionally, have been less liquid. Unfortunately, it appears that not all funds’ liquidity risk management practices have kept pace with these developments.
Today [September 22, 2015], the Commission considers proposing a set of rules and amendments that will help ensure that open-end investment companies—which include mutual funds and exchange traded funds—manage their liquidity risks in a prudent and responsible manner. The proposed changes will also help attenuate the dilution risks that confront long-term shareholders, and will give investors needed tools to monitor how well funds are managing their liquidity risk. These proposals are important, because they will adapt our decades-old liquidity regime to the fund industry’s new and vastly altered landscape. The proposals we consider today are especially timely, for at least two reasons. First, a study published just last night suggests that U.S. bond funds need to sharpen their methodologies for analyzing the liquidity of their portfolios, because their current methods might be inadequate. And second, a resurgence of volatility in the bond markets in recent months has, in concert with shifting market dynamics, thrust liquidity concerns in that space to the forefront.
These proposals are intended to foster a rigorous and analytically sound approach to liquidity risk management, while also helping investors to better gauge the ability of funds to fulfill redemption obligations.
Fund Liquidity, What is it Good For?
Why is liquidity such a paramount concern for open-end funds? The answer lies in the fact that these funds must stand ready each day to redeem an investor’s shares. This redemption feature benefits investors who want to exit these funds, but at the same time, it places concerns about liquidity risk firmly at the center of fund management. Virtually every investment decision made by an open-end fund is influenced by its obligation to redeem on demand, at least to some degree. Funds typically satisfy this obligation by maintaining a pool of liquid assets that can be converted to cash within three days, without a loss of value.
Needless to say, liquidity risk management is not an exact science. But, it is vitally important that open-end funds and their advisers get it right. For if they don’t, it is not just the redeeming investors who could be harmed, but also the remaining shareholders and, in extreme situations, the broader economy. A fund struggling to meet an unforeseen surge in redemptions may quickly deplete its pool of liquid assets, and be forced to sell less liquid assets at significantly discounted prices. Indeed, in some cases, assets might need to be sold at “fire sale” prices. Such forced sales can depress market prices for those assets, which, in turn, can dilute the value of the assets still held by the fund, or by other funds. The fear is that this could trigger a run on the funds, as investors attempt to preserve the value of their shares by submitting redemption requests before other investors do so. As we all know, such runs rarely end well for investors—or for the economy as a whole.
Further complicating matters, liquidity risk management has grown more challenging in recent years as investment strategies have evolved. As a white paper prepared by the Division of Economic and Risk Analysis shows, funds have increasingly gravitated towards potentially less liquid assets. For example, total assets invested in foreign bond funds have grown by more than 1,200 percent since 2000. Similarly, alternative mutual funds, which hold only 30 percent of their assets in equities on average, are the fastest growing segment of the fund industry. And, assets in domestic bond funds have increased by more than 130 percent since 2007, even as concerns about deteriorating liquidity in the bond market have grown more acute. The extent to which the fund landscape has shifted is illustrated by the fact that open-end mutual funds investing primarily in U.S. equities now represent only a minority of total industry assets.
Experts believe that the growing focus on potentially less liquid assets could make runs more likely—and raise the stakes if one occurs. As a recent study by the International Monetary Fund (IMF) has shown, forced sales of less liquid assets can have a greater impact on market prices than sales of more liquid assets. This creates an additional incentive for shareholders to redeem as early as possible, as a fund’s remaining shareholders may incur even steeper losses. The IMF study also points to other factors that could make runs more likely in today’s environment. For example, the report notes that herding behavior among investors has intensified in recent years, especially in the retail fund space. This suggests that one investor’s decision to redeem may now be more likely to spur other investors to do the same. These are ideal conditions for a run to take hold.
Today’s Proposals
So, how does the Commission address the liquidity challenges of open-end funds in today’s more complicated environment? Today’s [September 22, 2015] proposals represent a multi-faceted approach to these problems. I won’t go through all of the proposals, but I would like to highlight certain aspects that are noteworthy.
- Liquidity Risk Management Program: The proposal would, for the first time, require open-end funds to establish written liquidity risk management programs. Such programs would require funds to assess their liquidity risk against a non-exhaustive list of criteria, and to revisit these assessments periodically.
- Liquid Asset Minimum: Another core element of the proposal is that funds would be required to maintain a minimum level of highly liquid assets. Specifically, funds would be required to determine the percentage of their total holdings that must consist of assets that can be converted into cash within three days.
- Swing Pricing: To provide funds with the ability to ensure that investors bear the costs of exercising their redemption rights—and not pass on those costs to remaining shareholders—the proposal would permit funds to adopt partial swing pricing. This mechanism allows a fund, if its Board of Directors deems it appropriate, to adjust its NAV to account for the costs associated with redemptions and subscriptions above a certain threshold.
- Enhanced Disclosure Requirements: The proposal would also require funds to disclose more information about their liquidity risk management efforts, including the size of their three-day liquidity minimum.
- Redemptions-in-Kind: Finally, the proposal will remedy the oversight that funds are currently not required to have written policies and procedures to govern in-kind redemptions. In-kind redemptions may be rare, but advanced planning will keep funds from having to scramble to deal with them, if and when they take place.
These proposals recognize that liquidity risk management is a nuanced and dynamic process, one that resists a cookie-cutter approach. Accordingly, the proposals largely avoid an overly prescriptive method, and opt for guideposts that funds must follow in managing their unique risks. Notably, the proposal seeks comment on whether the Commission should take a more prescriptive approach with respect to certain types of funds that may present more risk. This is a crucial question, and I hope that commenters will provide thoughtful views on this point.
Finally, the proposals will also require funds to make more fulsome disclosures about their liquidity risks. This additional transparency should help to make runs less likely.
Conclusion
I will conclude by noting that investors of all types rely heavily on open-end funds to meet their savings and investment goals. By helping to ensure that such funds focus on how to remain liquid, even in times of market stress, the proposals will directly advance the Commission’s mission of protecting investors and facilitating capital formation. I will, therefore, support the recommendation.
