Two weeks ago I wrote my first in a series of posts on the SEC's proposed liquidity and redemption rules for mutual funds. The first post, available here, focused on swing pricing. Today's post will focus on the liquidity management proposals contained in the proposed rules to address liquidity risk.
The proposed rules would require all open end mutual funds (not UITs, closed-end funds or money management funds) to create a written liquidity management program and to disclose it to the SEC via the proposed forms N-CEN and N-PORT. Under the plan, funds would (1) classify and conduct ongoing reviews of liquidity of each of the fund's positions in portfolio assets, (ii) assess and conduct periodic reviews of the fund's liquidity risk, and (iii) manage the fund's liquidity risk through a set-aside minimum portion of fund assets that are convertible within 3 business days at a price that does not materially affect the value of that asset immediately prior to sale.
Liquidity risk is born of concern that a fund "could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materials affecting the fund’s net asset value." (Proposed Rules at 44-45).
Fund classification of portfolio liquidity is in addition to the 15% illiquid asset cap under current SEC guidelines (Release Nos. 33-6927; IC-18612, March 12, 1992). The proposed liquidity classifications "would require a fund to assess the liquidity of its portfolio positions individually, as well as the liquidity profile of the fund as a whole” and unlike the 15% cap to take "into account any market or other factors in considering an asset’s liquidity," and assess "whether the fund’s position size in a particular asset affects the liquidity of that asset." (Proposed Rules at 62-63).
A fund would assess the relative liquidity of each portfolio position based on the number of days within which it is determined, using information obtained after reasonable inquiry, that the fund’s position in an asset (or a portion of that asset) would be convertible to cash at a price that does not materially affect the value of that asset immediately prior to sale.” (Proposed Rules at 63-64). Funds would report portfolio classification in one of 6 categories of liquidity ranging from 1 day conversion to cash to 30 days conversion to cash to be reported on proposed N-PORT form.
The liquidity factors include:
o Existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants;
o Frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange);
o Volatility of trading prices for the asset;
o Bid-ask spreads for the asset;
o Whether the asset has a relatively standardized and simple structure;
o For fixed income securities, maturity and date of issue;
o Restrictions on trading of the asset and limitations on transfer of the asset;
o The size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and
o Relationship of the asset to another portfolio asset.”
(Proposed Rules at 80).
-Anne Tucker