The SEC has proposed a set of liquidity rules for mutual funds. This is an extension of the liquidity rules set-up for money market funds last year. The SEC says - know your liquidity.
Mutual funds and ETF's will have to bucket or categorize all assets held based on the ability to sell in a reasonable time. The purpose is to eliminate the potential for a run on the fund with forced liquidations by mutual funds in stock and bond markets in an effort to raise cash for redemptions. The SEC will also consider swing-pricing proposals on shareholder's trading activity.
The rules look for:
Mutual funds and ETF's will have to bucket or categorize all assets held based on the ability to sell in a reasonable time. The purpose is to eliminate the potential for a run on the fund with forced liquidations by mutual funds in stock and bond markets in an effort to raise cash for redemptions. The SEC will also consider swing-pricing proposals on shareholder's trading activity.
The rules look for:
- a classification of liquidity based on ability to sell in a timely fashion at reasonable prices based on six buckets related to the number of days to liquidate;
- an assessment of liquidity risk with a limit of 15% held in illiquid assets;
- establishment of a 3-day liquid asset minimums;
- board approval and review of the liquidity management plan and measurement.
These rules are coming out of the Financial Crisis in order to solve perceived liquidity problems in mutual funds. If you are going to allow daily liquidity of mutual funds, there is the potential for a liquidity crisis if the assets held cannot be sold on a daily basis. This is a classic bank liquidity problem when demand deposits can be withdrawn daily but the underlying investments of the bank may not be as liquid.
However, like the impact on money market funds, there will be unintended consequences. There will be a drag on mutual fund performance from forcing managers to weigh assets by liquidity buckets. Performance of funds will fall below the returns of benchmark indices. The cost of capital of less liquid assets will also increase. If you cannot prove you are liquid assets, you will trade at a discount. If there is a change in liquidity, there will be a negative feedback loop whereby assets will be sold based on perceived liquidity and not valuation. Life will be harder for managers and performance will deteriorate for investors based on the potential of a liquidity crisis. Liquidity will not be defined classified, and managed like never before and that will impact returns.
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