Know more about swing pricing in mutual funds!
There is a growing number of runs on open-ended mutual funds in India in recent times. We saw this in the case of IL & FS, which has continued till now. As experienced last year after the crash in the equity market & liquidity crunch when market conditions unexpectedly deteriorated, investors ran on open-ended funds especially credit risk funds, causing rampant redemption and making the situation worse for the fund and their investors. In such conditions, the first mover gets an inordinate advantage. We saw this last year in Franklin Templeton India episode, where a few senior employees withdrew their own money from the six wound-up debt schemes just a few days back before they were eventually wound up.
The market regulator, SEBI, in order to prevent the repetition of such cases, has issued a consultation paper on swing pricing. Alternative pricing or swing pricing adjust funds’ net asset values to pass on funds’ trading costs to transacting shareholders. It eliminates the first-mover advantage arising from the traditional pricing rule and significantly reduces redemptions during stress periods.
What is swing pricing?
Under the traditional pricing rule, mutual fund investors transact at the daily-close net asset value (NAV) of the fund portfolio. As a result, the price that a transacting shareholder receives does not consider the corresponding transaction costs that may arise because portfolio adjustments associate with shareholder transactions. Thus, the costs of providing liquidity to transacting shareholders are borne by non-transacting investors in the fund, which dilutes the value of their shares. This creates a first-mover advantage and creates incentives to run on funds, especially during market-wide stress when market liquidity typically drops what we saw last year. The incentives to run on funds depend on the liquidity mismatch between assets invested in by the funds & liabilities demanded by the investors.
Swing pricing or dual pricing aims to adjust funds’ NAV so as to pass on the costs stemming from transactions to the shareholders associated with that activity. The goal of swing pricing is to protect the interests of non-transacting shareholders by offering them a better price.
Swing pricing rules take primarily in two different forms. The first one is full swing pricing, whereby, a fund’s NAV can be adjusted up or down on every trading day in the direction of net fund flows: If net flows are positive, the NAV shifts up while if the net flows are negative, the NAV shifts down. The magnitude of the shift is known as the adjustment factor. The second form i.e. the partial swing pricing is invoked only when net flows cross a pre-determined threshold, namely, the swing threshold. The swing factor is an estimate of the ‘costs’ of trading taking into account spreads, transactions costs & relevant taxes.
Although, the concept looks good but there are certain challenges that need to be addressed before it can be implemented. For example, who would trigger swing pricing? The proposal defines two situations; first is a market dislocation triggering a mandatory swing pricing across fund houses as directed by SEBI while the second situation is where individual asset managers could face liquidity constraints in their schemes and will have the discretion to use the provisions of swing pricing. In both cases, it needs to be communicated to investors while its implementation needs to be sorted out. Besides, the suggested 1-2 per cent of swing pricing will be harsh for some debt funds that have a lower yield.
Nevertheless, it is yet another step in the right direction by the regulator to protect the interest of retail investors.
Illustration of swing pricing:
A basis point adjustment, known as the swing factor, is then applied to adjust the NAV per share - up where there are net inflows or down in the case of net outflows. The swing factor is an estimate of the ‘costs’ of trading, taking into account, spreads, transactions costs & relevant taxes.
The simple example below demonstrates how the NAV per share would be adjusted based on whether there are 1) no material flows; 2) material inflows; or 3) material outflows.
For the purposes of this semi-swing example, assume that the NAV per share is Rs 10 while the swing factor adjustment is 50 basis points (bps):
No material flows above swing threshold:
Material net inflows exceed swing threshold:
NAV per share swings up by 50 bps
Publish a NAV per share of Rs 10.05
The shareholder trading on the day receives fewer shares in issue for their monetary investment to compensate existing shareholders for the dilution incurred on the fund.
Material net outflows exceed swing threshold:
NAV per share swings down by 50 bps
Publish a NAV per share of Rs9.95
The redeeming shareholder receives fewer proceeds for their shares in issue to compensate the existing shareholders for the dilution being caused.