The final swing of the 2018 baseball season will take place on October 31 next year, assuming the World Series goes to game seven. But it’s in mid-November that investors will find out if funds are prepared to step up to the plate and start swinging.
That’s because in a little over a year’s time, an amendment to the Investment Company Act will come into effect, permitting funds to employ swing pricing. This is a practice whereby funds can pass on the costs of meeting redemptions to sellers, rather than leaving the remaining investors to bear those expenses.
This was approved by the Securities and Exchange Commission in November 2016, but its implementation was delayed for two years to allow the industry time to prepare its infrastructure for the switch.
However, swing pricing has been common practice in Europe for many years and the experience there may reveal what lies ahead for the US. It’s an issue explored in a new paper by Ulf Lewrick and Jochen Schanz of the Bank for International Settlements.
The European way
Lewrick and Schanz contrasted the recent performance of bond funds in the US with those domiciled in Luxembourg, a major European fund-management hub. They focused on fixed income for its relatively less-liquid profile: it is generally easier and cheaper for a fund to dispose of shares to manage outflows, and this lower level of trading friction means swing pricing makes less of a difference. They also excluded government bond funds for this reason.
Their sample period of January 2012 to May 2016 reflects the availability of data for the Luxembourg funds, and includes the ‘taper tantrum’ of 2013 as an important stress test for the portfolios. Overall, they analyzed 1,000 US funds and 719 in Luxembourg.
Broadly, flows into and out of the two sets of funds were highly correlated: investors in America and Europe made similar allocations to bonds at the same times. Differences in the magnitude of redemptions emerged, though, when both individual strategies and the asset class underperformed.
European bond managers, for example, were penalized less when they lost money. If a Luxembourg fund lost 10% in a month, it was hit with excess net outflows equivalent to 0.25% of the fund’s total assets. But when US funds dropped by the same amount, they were subject to additional net outflows worth 0.52% of the fund’s value.
This is consistent with the incentives created by swing pricing: pulling out of underperforming funds is no longer cost-free, making potential sellers more reluctant.
That evidently suits weaker managers. In theory, that negative consequence of swing pricing should be countered not only by apportioning redemption costs more fairly but also by making a run on the fund less likely. Swing pricing should negate the first-mover advantage of dumping a fund quickly, minimizing the risk that those who stay loyal will be exposed to a fire sale.
The problem is that that was not what happened during the 2013 taper tantrum. Despite swing pricing, the Luxembourg funds still suffered more than double the normal negative effect of outflows on returns during this episode.
‘Had swing-pricing policies fully offset first-mover advantages during the taper tantrum, there should have been no significant increase in the flow-to-performance relation,’ Lewrick and Schanz noted. But facing a collapse in bond prices, investors decided that the extra costs for redeeming through swing pricing were marginal.
Hitting the buffer
A final intriguing observation in the study was that the Luxembourg funds held an average of 0.98 percentage points less cash than their US counterparts. This makes sense if they do not have to worry about passing on the expense of liquidating assets to their steadfast investors.
If markets are strong, investors should welcome that lower cash drag. But this trait of swing pricing could also amplify risks, and not simply by increasing the exposure to downturns. ‘Reduced cash holdings could aggravate investor incentives to withdraw during stress episodes,’ Lewrick and Schanz explained. Swing pricing could therefore create one of the problems it is supposed to solve.
This could be mitigated by imposing minimum liquidity requirements on funds, Lewrick and Schanz suggested, but such shackles would of course constrain returns.