To ensure a level playing field for all investors (entering, exiting and existing) in mutual funds, particularly during market dislocation, Securities and Exchange Board of India (SEBI), has floated a consultation paper to introduce swing pricing mechanism in open ended debt funds which contain high risk. The regulator has sought the industry's feedback on this paper by August 20, 2021.
Swing Pricing
Suppose a fund managing Rs 100 crore worth assets gets a redemption request from a large institutional investor for Rs 10 crore, which is 10% of the fund’s AUM, the fund house will first tap into its liquid reserves to meet the redemption request. Swing pricing may get invoked based on the threshold set by the AMC or the industry. Let us assume it is 5% of the AUM in this case. The fund manager will sell the securities in the market. However, the fund manager may not get the desired price for liquidating the security, especially when the market for the underlying security is illiquid. Additionally, the fund will incur trading/transaction cost which will eat up fund’s return, reflecting in the NAV. As a result, investors who remain invested in the fund are at a disadvantage. To penalise investors who are going out that day, the AMC adjusts the NAV downwards which accounts for the trading, taxes and liquidity cost. This ensures that the trading costs are borne by the exiting investor.
The fund house adjusts the scheme’s net asset value (NAV) up or down to effectively pass on transaction costs arising from investors moving in or out of the scheme.
Scenario 1
If the net inflows exceed a threshold, NAV is adjusted upward. This way, investors trading on that receive less units since NAV is adjusted upwards. The higher the NAV, lesser units you get and vice versa.
Scenario 2
If the net outflow exceeds a threshold, NAV is adjusted downward. This ensures that investors redeeming on that day compensate existing investors since exiting investors get fewer proceeds from downward adjusted NAV. The lower the NAV, the lower the redemption value.
The swing pricing threshold is not disclosed in the public domain as it may encourage some investors to invest or redeem just below the threshold level to bypass the rule. Swing Pricing is already practiced in markets like U.S., Luxembourg, Hong Kong, France and U.K.
Rationale
SEBI felt that there is a need for a mechanism that imposes a certain costs on exiting investors (since they are contributing to a downward spiral in NAV) while incentivizing entering investors (since they are helping to stem the downward spiral in NAV). The regulator has proposed a partial swing during normal times and a mandatory full swing during times of market dislocation.
Types of Swing Pricing:
Full Swing
In this case, the NAV of a fund adjusts up or down every calculation day regardless of the size of the investor dealing.
Partial Swing
It is only invoked when the net inflow or outflow is greater than a certain pre-determined % of AUM.
SEBI's proposal regarding Swing Pricing:
During normal time
- Applicability of swing pricing will be optional based on pre-determined minimum swing threshold and maximum swing factor.
During market dislocation
- Swing pricing framework will be implemented in a phased manner. In the first phase, it shall be mandated only during the times of outflow market dislocation across mutual funds as it is a high-risk scenario.
- During market dislocation, the applicability of minimum swing factor will be as stipulated by SEBI which shall be risk-based. Beyond this, AMCs can choose to levy a 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 viz. redemption pressure, current portfolio of the scheme as detailed in the scheme information document (SID). This will be subject to compliance to pre-disclosed cap on swing factor and minimum swing threshold.
- During market dislocation times, the mandatory swing pricing shall apply to all the schemes which have High or Very High risk on the risk-o-meter and classify themselves in certain high risk cells of Potential Risk Class (PRC) Matrix.
- SEBI will determine ‘market dislocation’ either based on Association of Mutual Funds in India (AMFI)’s recommendation or based on combination of various factors like net redemption build up at industry level, global market indicators, Indian market indicators as well as bond market indicators. Once market dislocation is declared, it will be broadcasted that swing pricing will be applicable for a certain period, which can be extensible.
- Swing pricing will be mandatory for high risk open ended debt schemes during market dislocation, as these schemes carry high risk securities compared to other schemes which possibly have higher costs of liquidation.
- During times of market dislocation, all schemes will give effect to swing pricing and certain minimum uniform swing factor shall be made applicable across the industry. However, when there is a scheme level stress, the fund manager shall determine whether to apply swing factor or not.
- Accordingly, the scheme performance is reported without taking into account the mandatory swing factor during market dislocation but after adjusting NAV for the swing factor during normal times and adjusting NAV for the swing factor if additional discretionary swing factor is levied by the AMC during stress.
- When swing pricing mechanism is triggered and swing factor is made applicable (during normal time or market dislocation, as the case may be), both the entering and exiting investors shall get NAV adjusted for swing pricing.
- Swing Pricing is exempted for redemptions up to Rs 2 lakh for all investors and up to Rs 5 lakh for senior citizens at mutual fund level.
- In subsequent phases, SEBI will examine the applicability of Swing Pricing mechanism to Equity Schemes, Hybrid Schemes, Solution oriented schemes and Other schemes (viz. Index Funds/ETFs).
Access the consultation paper here.
