United States: SEC To Permit "Swing Pricing" For Open-End Funds

The Securities and Exchange Commission (the "SEC") has now codified a new mechanism to deal with the risk of dilution in the value of mutual fund shares caused by ordinary purchase and redemption activities. The mechanism is referred to as "swing pricing" and it can be found in a new subparagraph (a)(3) of Rule 22c-1 under the Investment Company Act of 1940 (the "1940 Act").

Swing pricing will permit funds to adjust their net asset value ("NAV") under specified circumstances to cause the costs stemming from shareholder purchase and redemption activity to be shared with the purchasing or redeeming shareholders. Swing pricing will be optional for eligible funds, but will not be available for any funds until October 2018.

The Motivation for Swing Pricing

The SEC's acceptance of the concept of swing pricing (which has been practiced in the EU for over 15 years) evidences its concern with the risk of shareholder dilution resulting from transaction costs that arise when shareholders either purchase or redeem shares of a fund. The SEC noted in its adopting release that a fund's NAV at the end of each day typically does not reflect the costs of shareholder transactions occurring during the day. As a result, transaction costs are born by shareholders remaining in the fund (i.e., the "non-redeemers"). The SEC has also noted that swing pricing could help deter redemptions motivated by any "first-mover" advantage – i.e., shareholders who might otherwise seek to redeem large holdings quickly and ahead of most other shareholders would now be deterred by having to bear part of the costs associated with their redemption.

Additionally, the SEC has been concerned with the risk that a fund may be unable to meet its obligations to redeeming shareholders as a result of liquidity risk. The SEC has observed that the less liquid a fund's portfolio holdings become, the greater these liquidity costs can be. The significant growth in the assets managed by funds with strategies that focus on holding relatively less liquid investments (e.g., fixed income funds, emerging market funds, alternative strategies funds), which can incur significant trading costs, may give rise to increased dilutive effects from redeeming and subscribing shareholders in those funds.

The SEC's response to these concerns was to amend Rule 22c-1 to allow (but not mandate) a fund to adjust its NAV to account for these transaction costs. The new provision applies to open-end funds other than money market funds and exchange-traded funds.

Mechanics of Swing Pricing

Swing pricing works by allowing a fund to respond to significant purchase or redemption activity on a trading day by artificially reducing its net asset value ("NAV") for that day to account for the added portfolio trading costs to the fund resulting from that activity.

The Swing Factor

The amount by which a fund can reduce its NAV is referred to as the "swing factor." It is a percentage of NAV, with a maximum of two percent, although the exact percentage to be applied to NAV at any time may fluctuate based on the judgment of the fund officer charged with administering the swing pricing program ("swing pricing administrator"). In making this determination, the swing pricing administrator may only take into account the near-term costs expected to be incurred by the fund as a result of net purchases or net redemptions on the day the swing factor is used, such as spread costs, transaction fees and charges arising from asset purchases or asset sales to satisfy those purchases or redemptions, and borrowing related costs associated with satisfying redemptions. Market impact costs may not be considered when setting the swing factor.

The Swing Threshold

The trigger for applying a swing factor is referred to as a "swing threshold." The swing threshold is stated as a percentage of the fund's NAV and is the level of net purchases or redemptions on a day which, if exceeded, requires application of the swing factor to determine the fund's NAV for that day.

The SEC has noted that a fund's swing threshold should generally reflect the estimated point at which net purchases or net redemptions would compel the fund's investment adviser to trade portfolio assets in the near term, to a degree or of a type that may generate material liquidity or transaction costs for the fund. A fund is permitted to set multiple swing thresholds (and to establish different swing factors for different swing thresholds). When determining if the swing threshold has been exceeded, the swing pricing administrator will make this determination based on his or her receipt of sufficient information about the fund shareholders' daily purchase and redemption activity to allow the fund to reasonably estimate, with "high confidence," whether it has crossed the swing threshold.

Swing Pricing Policies and Procedures; Board Review and Approval

If a fund chooses to utilize swing pricing, it must establish and implement swing pricing policies and procedures required by Rule 22c-1(a)(3). The fund's swing pricing policies and procedures must specify the process for establishing the swing threshold, the swing factor and the upper limit of the swing factor. When determining a fund's swing threshold, the SEC mandates that a fund consider the following factors:

  • The size, frequency, and volatility of historical net purchases or net redemptions of fund shares during normal and stressed periods;
  • The fund's investment strategy and the liquidity of the fund's portfolio investments;
  • The fund's holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources; and
  • The costs associated with transactions in the markets in which the fund invests.

A fund's board of directors must approve the fund's initial swing pricing policies and procedures, as well as the fund's swing threshold(s) and swing factor upper limit. The board is not required to approve any material changes to the fund's swing pricing policies and procedures after its initial approval, but must approve any changes to the fund's swing threshold or swing factor upper limit.

The board must also designate the fund's swing pricing administrator responsible for administering the fund's swing pricing policies and procedures. A fund's swing pricing policies and procedures must also require that the swing pricing administrator make a determination that the swing factors used are reasonable in relationship to the fund's costs in meeting net shareholder subscriptions and redemptions. Administration of swing pricing must be reasonably segregated from portfolio management of the fund and may not include portfolio managers.

No less than annually, the fund's board of directors must review a written report prepared by the swing pricing administrator that describes (i) the swing pricing administrator's review of the adequacy of the fund's swing pricing policies and procedures and the effectiveness of their implementation, including the impact on mitigating dilution; and (ii) its review and assessment of the swing threshold, swing factor and swing factor upper limit.

Record Keeping Requirements

Under amendments to Rule 31a-2(a)(2) under the 1940 Act, a fund is required to keep records supporting each computation of the fund's NAV and any adjustments to the NAV based on the fund's swing pricing policies and procedures. Specifically, for each adjusted NAV, records should generally include the fund's unswung NAV, the level of net purchases or net redemptions that the fund encountered (and estimated) that triggered the application of swing pricing, the swing factor that was used to adjust the fund's NAV, relevant data supporting the calculation of the swing factor, and any back-testing data used by the fund in assessing the swing factor (and its relationship to near term costs expected to be incurred by the fund as a result of net purchases or net redemptions that occur on the day the swing factor is used). The records must be preserved for at least six years from the date the NAV adjustment occurred, the first two years in an easily accessible place.

Reporting Requirements

Amendments to Item 6 of Form N-1A require that a fund that uses swing pricing must explain the fund's use of swing pricing, including its meaning, the circumstances under which the fund will use it, and the effects of swing pricing on the fund and investments. The fund must also disclose the swing factor upper limit it has set. For a fund that invests in other funds that use swing pricing, the fund is required to include a statement that its NAV is calculated based on the NAVs of the funds in which it invests, and that the prospectuses for those underlying funds explain the circumstances under which those funds will use swing pricing and the effects of using swing pricing.

Amendments to Item 13 of Form N-1A now require disclosure of the swung NAV per share as a separate line item below the ending GAAP NAV per share on the financial highlights. The per share impact of amounts related to swing pricing must be disclosed below the total distributions line in a fund's financial highlights and a general description of the effects of swing pricing on the fund's financial statements must also be disclosed. Funds that utilize swing pricing must also include a footnote that describes the effects of swing pricing on the fund's annual total return bar chart and average annual total returns table, and additional disclosures in the prospectus financial highlights with respect to the per share impact of amounts related to swing pricing in the NAV per-share roll-forward, as well as the swung NAV per share. Funds must also disclose their swing factor upper limit on Form N-1A and Form N-CEN.

The SEC has also adopted a new reporting item under Part C of Form N-CEN which requires a fund to disclose whether it engaged in swing pricing during the reporting period, and if so, the swing factor upper limit set by the fund.

A fund that adopts swing pricing policies and procedures must also disclose in a footnote to its financial statements (i) the general methods used in determining whether the fund's net asset value per share will swing, (ii) whether the fund's net asset value per share has swung during the period, and (iii) a general description of the effects of swing pricing on the fund's financial statements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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