OREANDA-NEWS. October 13, 2015.  New SEC proposals requiring US retail investment managers to formalize liquidity risk management for mutual funds and ETFs could leave the funds better equipped to handle bouts of market volatility, but there may be unintended consequences, says Fitch Ratings.

The proposals could exacerbate the threat of declining market liquidity by increasing fund managers' aversion to less liquid fixed-income assets, particularly for smaller issues and less traded sectors. Small issues and sectors such as emerging markets and high yield, which are already traded less frequently, could see marginally weaker interest from bond mutual funds and ETFs.

The inclusion of "swing pricing" in the proposals may be an important offset to any negative side effects on less liquid areas of the bond and loan markets. Swing pricing would permit a fund to be required, under certain circumstances, to effectively allocate the transaction costs of selling assets to the selling shareholder, as opposed to all shareholders. Fitch believes swing pricing could be an effective influence on investors' behavior as it is a disincentive to trading under high-volatility conditions. Its influence could curb potential market dislocations in the first place. Some foreign funds already use swing pricing to pass on transaction costs to those security holders that are actively trading during high volatility, thus limiting the impact of those trading costs on the shareholders not trading.

Additionally, alternatives to open-ended funds may become more attractive for less liquid issuers and sectors. Closed-end funds, which are not part of the regulation, may become more attractive for investment managers when creating funds focused on less liquid securities.

The SEC's proposals are designed to strengthen protections for fund shareholders. They could be a positive for individual investors in bond mutual funds when markets are strained as the funds should cope better with the volatility, but for a seller the swing pricing could leave them worse off. The cost of any improvement however, could be that managers who deal in less liquid areas of the market, may have to assume higher levels of "cash drag."

The timing of the proposal is important because fixed-income mutual funds and ETFs are facing a structural shift in market liquidity. The potential has risen for "capacity constraints" in the event that funds see a surge in redemptions. In a Fitch evaluation of the holdings of the five largest US investment-grade ETFs in November 2014, only about 5% of the underlying bonds in the middle 50th percentile holdings traded daily. On the other hand, of the largest 25 holdings in each of these same five ETFs, 54% traded daily.

If adopted, retail fund liquidity programs would be required to determine whether an asset could reasonably meet the standards for being a "three-day liquid asset." The SEC envisions a total of six liquidity buckets, based mostly on the time expected to liquidate the asset, ranging from one day to over 30 days. Managers would be required to maintain their three-day liquid assets above minimum thresholds defined by the fund's boards. Instating formal liquidity programs, meeting disclosure requirements and bearing the risk of more SEC scrutiny will add costs and have strategy implications for the retail fund industry.