Swing pricing will help reduce the first-mover advantage during high redemptions in debt schemes and materially reduce risk of run on the fund, says Sebi
In order to discourage large investors from sudden redemption and ensure fairness of treatment of entering, exiting and existing investors in open-ended debt mutual fund schemes, Securities and Exchange Board of India (Sebi) has proposed the concept of swing pricing. It will be partial during normal times and a mandatory full swing will come into force on high stress or market dislocation.
Swing pricing will help reduce the first-mover advantage during high redemptions in schemes and materially reduce risk of run on the fund. Typically, in case of large outflows in debt funds, fund managers are forced to sell high quality and most liquid paper to pay for redemption pressure. As a result, existing investors are saddled with low quality paper difficult to sell as the secondary bond market in the country is not as liquid as the equity market and can absorb only a limited amount of paper on any given day.
Swing pricing will help in adjusting a fund’s net asset value (NAV) to effectively pass on transaction costs arising from flows into or out of the fund to the investors associated with that activity during the life of a fund. Sebi has proposed high-risk schemes (C-III category) will have a swing of 2%, which means during times of distress, those investors who redeem their units will have to take a 2% lower NAV. However, the markets regulator has underlined that swing pricing will not be applicable for redemptions of up to `2 lakh for all unit holders (retail investors) and up to `5 lakh for senior citizens.
Experts say swing pricing will help to restore trust in mutual fund debt schemes after Franklin Templeton announced winding up of six debt schemes investing in lower credit rated papers in April last year as investors redeemed from credit risk funds and other funds investing in lower credit rated instruments.
Protecting retail investors
In a liquidity-challenged environment, Sebi’s consultation paper for introduction of swing pricing underlines that the quoted bid/ask spreads and overall trading cost can widen and may not be representative of the executed prices that can be achieved in the market. “In such circumstances, swing pricing can be a useful mechanism to contribute to protect the interests of existing investors, specifically from the dilution of their holdings and contribute to protect the value of the investors’ capital,” it says.
So, when swing pricing is set because of high redemption or high inflows– a practice followed in most developed markets such as the US, the UK – the NAV of the scheme will move up or down and the investor pulling money out of the scheme or those investing in the scheme will have to bear the trading costs and the existing investors will not be affected.
“Further, liquidity is concentrated in high quality paper and during market dislocation, very high risk aversion is observed and in terms of yield of bonds, spread over benchmark spike, particularly for relatively lower quality paper,” Sebi’s consultation paper says.
Cost on exiting investors
So, swing pricing will impose a certain cost on investors who are redeeming as they are contributing to a downward spiral in the NAV and will incentivise entering investors as they are helping to stem the downward spiral in the NAV. This NAV will be adjusted downwards during times when net outflows are more than the swing threshold and this lower NAV will be offered to the entering investors during such times.
“During market dislocation, complete cost of transaction, illiquidity cost amongst other costs may not be reflected in NAV and those investors who redeem when the scheme has liquidity buffer to meet the redemption requests get better NAV than those who redeem after the liquidity buffer held by the scheme is over,” the regulator’s papers says.
During market dislocation, the minimum swing factor will be as stipulated by the markets regulator which will be risk-based. Beyond that, the fund house can choose to levy higher swing factor if it considers such a factor to be in the best and equitable interest of its unitholders, based on pre-defined parameters.