Swing pricing in fund valuation. A modern shield from dilution.
The question of how to protect investors from the dilution of their returns, which is caused by the transaction costs related to inbound and outbound capital, has always been a concern of the investment fund industry. How swing pricing can offer protection in volatile markets.
Traditionally, a unit share of a fund is traded with a bid/ask spread. A commonly adopted market standard is to set fixed issue and redemption spreads, equal to a total of explicit (commissions, brokerage etc.) and implicit transaction costs (average market bid/ask spreads) for the primary assets in which a fund invests. The spreads are expected to be stable over a long period of time and are published.
However, fixed issue and redemption spreads and their governance model may not be able to anticipate any significant fluctuations of the liquidity on the market. Thus, if a fund invests in the asset classes or market segments particularly susceptible to volatile implicit transaction costs, the liquidity risk management becomes more challenging. In addition, the consequences of the global financial crisis in 2008 have shown that even regional issues may quickly cause systemic problems worldwide. Having said that, the recent events have once again proven that the markets may lose traction easier than one might have thought.
Swing pricing for the liquidity management
With the swing-pricing method (often called SSP, single swinging price), the concerns of liquidity risk management related to volatile markets can be (partially) addressed. In general, the swing-pricing framework makes it possible to immediately adjust the NAV to reflect the most actual market transaction costs or even effective costs of a single cash flow. Instead of dual pricing, the price is singular, but may be increased or decreased depending on the direction of a trade, taking into consideration net flows and the overall impact on liquidity.
Under the popular partial swinging regime in the EU, the adjustment only "kicks in" when the net flow exceeds the previously determined threshold. If the flows are low and the liquidity is thus manageable, the SSP doesn't distort the performance as there is no need to do so.
Typically, a transaction costs p.a. range from 10 to 50 bps, with blue chip equity or sovereign bond funds on one side and high yield credit, small cap equities, and alternatives on the other side of the spectrum. Nevertheless, a large sellout due to a massive redemption from a fund in a shallow market alone may even result in a twofold increase of a spread, as there are not that many good bids to be found. Moving on, in the event of abrupt and systemic turmoil which affects entire markets, the spreads may quadruple or even exceed the maximum levels of anti-dilution measures that are allowed by the sales prospectus.
The COVID-19 outbreak and the lockdowns in the first quarter of 2020 and the Russian invasion of Ukraine in February 2022 are prime and recent examples. Based on intense interaction with the regulators in 2020, they provide for greater flexibility/higher maximum swings in the event of distressed markets.
The impact of COVID-19 and the war in Ukraine on the equity markets
During the first stage of the pandemic, equity markets were obviously hit with respect to stock valuations, but still remained fairly liquid. Fixed income however – especially financial, high yield and/or industries, i.e. the ones expected to be strongly affected by supply chain disruptions – immediately became inefficient. The subsequent recovery path was also uneven as well as being dependent on the decisions of various central banks, the spread of the virus, and the actions of policymakers.
The war in Ukraine on the other hand hampered the liquidity of the entire European emerging markets in terms of both equities and fixed income. The subsequent recovery followed a complex and unpredictable pattern, based on the magnitude and aim of the sanctions placed on Russia, as well the disruptions of supply and industrial output caused by the war. Some segments regained traction in good time (i.e. Eastern European equities ex. Russia), while others became completely illiquid and even led to write offs (Russian local currency bonds and equities).
Reducing risks with swing pricing
In such difficult conditions, traditional anti-dilution measures would in many cases lead to the decision to suspend a fund, postpone its NAV calculation, restrict capital flows, or even put it in liquidation. However, the swing pricing made it possible to mitigate those risks in these situations and to keep the situation under control without having a negative effect on the interest of long-term shareholders. This was possible thanks to its framework, which is based on the following principles:
- Constant monitoring of the liquidity of both the target markets and the investment funds in scope.
- Robust SSP factor estimation model with all the necessary input parameters.
- Strong expert judgment incorporated into the model-based platform.
- Rigid framework with strong governance and oversight.
- Capability to back-test the results and continuously develop the model and adopt processes.
Properly implemented swing pricing makes it possible to strengthen liquidity risk management under all possible market conditions and can be considered as an additional liquidity management tool. This can be achieved by building adaptive processes, including ad hoc or emergency SSP Committee proceedings, applications of effective spreads for particular transactions, and having experts and powerful tools working in conjunction, e.g. on automated calculations.
Governance allows rapid action in liquidity management
Governance is of an equal importance. In the Committee framework, a pricing agent is expected to provide upswing and downswing suggestions based on the adopted model. Afterwards, various experts such as investment managers and representatives of Risk Management are tasked with assessing the proposal. Eventually – depending on the setup – the Management Board or Board of Directors of a fund company will approve or reject the new SSP factors.
Such governance model makes it possible to act swiftly, but also balances the views and makes sure that actions are taken in the interest of investors. The frequency of such revisions may vary from quarterly to even daily, depending on the volatility of the markets. This is one of the key strengths of swing pricing.
Investing in innovation around swing pricing
Although swing pricing has proven to be an effective tool, it is however important to remember that it also comes with a price of its own. Therefore, it may not be the best choice for everyone, i.e. for products or strategies that are not geared with long-term investing in mind, or if a fund is holding very liquid assets (i.e. money market funds, large cap equities on development markets, or ETFs). The same goes for fairly small vehicles, in terms of both AuM and the pool of clients. There, the application of swing pricing may simply be an overshoot.
In order for the SSP to be state of the art, this would require investments – in the knowledge base, the evolution of best practices, and technical solutions. A large degree of automation and a wide range of data is needed in order to yield accurate estimates that can bear scrutiny. Credit Suisse Asset Servicing is also keeping a close eye on developments surrounding SSP and is investing actively in innovative services. There is great conviction that flexible spreads are the future when it comes to pricing the types of funds, whereas liquidity risk management may become challenging.