How the SEC’s Latest Proposal Might Impact the Face of Mutual Funds

It has been six years since the Securities Exchange Commission (SEC) adopted three significant rules and reforms impacting open-end mutual funds: Rule 22e-4 requiring Liquidity Risk Management Programs, the addition of paragraph (a)(3) to Rule 22c-1 to allow the optional use of swing pricing, and Investment Company Reporting Modernization, which introduced Forms N- PORT and N-CEN.

On November 2, 2022, the SEC released a new proposal, this time combining proposed changes covering all three of these topics into one 429-page release which would change the game for open-end funds yet again. With the stated objective of improving liquidity risk management programs to “better prepare funds for stressed conditions and improve transparency” and to “mitigate dilution of shareholders’ interests in a fund,” the proposed changes would alter the face of the US mutual funds industry and have broad impacts to how funds are sold and serviced in the US.

The proposal includes several substantial changes to Liquidity Risk Management Program rules, including changes to bucketing classifications and Highly Liquid Investment Minimums, modifications to Form N-PORT reporting including a stepped-up filing frequency, and other filing amendments (N-1A and N-CEN). However, the mandatory use of swing pricing, a model that adjusts a fund’s current NAV in order to protect non-trading investors from bearing the impact of portfolio trading costs, and the “Hard Close” that is the SEC’s suggested solution to operationalize swing pricing, may be the most controversial of the proposed rule changes.

Following the 2016 changes that allowed optional swing pricing, none of the US open-end funds adopted the practice. Although several global asset managers use swing pricing in their European products, the practical application in the US market has not followed. Reasons for this include the trading model and the significant proportion of US mutual fund assets that are held by retirement investors, making the timing of order receipt in the US market less conducive to swing pricing.

The new proposal would require open-end funds other than money markets and ETFs to use swing pricing as an anti-dilution tool. In a departure from the optional swing pricing practice that is in place today, funds would be

required to swing the NAV on any day that the fund was in net redemptions, with no swing threshold. For days with net purchases that exceed 2% of the fund’s net assets, swing pricing would also be required.

While the swing factor may still be determined on a periodic basis, the proposal outlines the SEC’s expectations for the calculation of the swing factor, including a standardized approach to estimate the costs of selling or buying a pro-rata amount of each portfolio investment, (a “vertical slice”), spread costs, commissions, fees, and taxes associated with portfolio investment transactions, and market impact. In the case of redemptions, the proposal sets a market impact threshold at 1%. Notably, the swing pricing administrator cannot be a fund’s portfolio manager.

On the surface, the hard close proposal seems simple: for an order to receive the current day’s NAV, the order must be received by the fund’s transfer agent or a registered clearing agency (currently, only the National Securities Clearing Corporation (NSCC) in the US), by the pricing time (generally 4:00 pm EST). However, in practice, this change would not be so simple – while the SEC outlines the hard close proposal as the answer to the US industry’s ability to implement swing pricing, the impacts would be far-reaching.

US 401(k) plans held $6.3 trillion in assets at the end of Q3 2022 (per the Investment Company Institute and Department of Labor), with $3.8 trillion of those assets (61%) investing in mutual funds. The current market practice and agency trading model allows those investors to direct transactions in their retirement accounts until the prospectus closing time for the fund. Intermediaries and retirement plan recordkeepers are responsible to uphold the fund prospectus cutoffs to investors, but may transmit orders to the funds after close, until a mutually agreed upon time. The additional administrative time allows for order aggregation and/or netting at the plan or omnibus account level.

The proposal acknowledges that systems and business practices would require significant changes, and that some intermediaries may establish cutoff times that would be earlier than the fund prospectus cutoff times. The proposal cites the advancement of technology as the foundation for the belief that the intermediary cutoff times would not need to be significantly earlier than the pricing time established by the funds. Orders would be considered irrevocable, with no trade cancellations permitted.

The impact on the end investor is noted in the proposal, but the SEC’s belief is that the orders are not time sensitive as most fund shareholders are long term investors. The proposal cites the protections provided by swing pricing as a benefit that would outweigh the adverse impact of an earlier cutoff, and notes that investors wishing to transact until 3:59 PM ET could “generally place orders with the fund’s transfer agent to retain this option.” In practice, this option would not be feasible for investors holding fund shares through their 401(k) plan accounts.

Although the proposal is specifically applicable to open-end mutual funds other than money markets and ETFs, a move to a hard close would likely impact other products offered in 401(k) plans, such as Collective Investment Trusts, as intermediaries and retirement plan recordkeepers would likely align systems processes and cutoffs times across fund types rather than supporting different processes for mutual funds and CIT’s. This further broadens the impact on the end investor.

The proposal notes that in Europe, where swing pricing has long been used as a tool, the hard close is common. There are two significant distinctions between the European market standard and the SEC proposal, however. First, swing pricing in Europe is not required – it is permitted. Second, the hard close construct was a European market standard prior to the movement toward intermediated positions and toward defined contribution plans, providing investors with opportunity up front to understand and accept any earlier cutoff times, rather than losing flexibility on their order timing after the fact.

The proposal has outlined several specific questions for comment. All comments on the proposal were due by February 14, 2023.