On October 13, 2016, the Securities and Exchange Commission (SEC) announced a new set of rules to address mutual fund liquidity risks. Rule 22e-4, called the “Final Rule,” requires each registered open-end management investment company, like a mutual fund, to establish a robust liquidity risk management procedure.
This new rule and the procedures with which each mutual fund will need to comply officially go into effect on December 1, 2018.
To familiarize yourself with regulations governing the mutual fund industry, read about the Investment Company Act of 1940.
The Need for the New Rule
The SEC created this new rule because open-ended mutual funds are not currently subject to requirements under federal securities law that requires them to manage their liquidity risk. There are several guidelines that funds should limit their exposure to illiquid assets, but there is no official law mandating this policy.
The goal of the financial industry is to allow individual investors to pool their risk-taking activities. This is similar to the home insurance industry that routinely provides home insurance by grouping similar people according to the risks in their area. If many residents live in an area that is subject to natural disasters like earthquakes or hurricanes, everyone in that area is charged a similar rate as opposed to people who do not live in high-risk areas. Through mutual funds, the investment industry can pool the risks of many individual investors, like the insurance business. As a benefit to investors, a mutual fund can offer more diversification and access to investments that are normally not offered to individual investors but only institutions.
Learn more about the implications of liquidity risks for mutual funds here.
Liquidity Risk and the Current Rule
One of the issues that caused the change for the new ruling is that the SEC wanted to reduce the liquidity risk that investors have with mutual funds. Liquidity risk in this case is when an investor decides to sell all or part of their investment and the fund manager cannot provide the funds within a reasonable time. This type of risk is more common in down or volatile markets where the fund cannot meet the redemption needs of all the outgoing funds. Typically, mutual funds keep a certain amount of cash or short-term instruments to meet the needs of investors who want to redeem. However, if too many investors decide to pull out at the same time, the fund will have to start selling off its holdings rapidly, causing a reduction in the fund’s net asset value.
Another issue for investors and liquidity risk has to do with a fund’s holdings and its level of illiquid investments. Previously, there was a longstanding 15% guideline that limits a mutual fund to aggregate holdings of illiquid assets to 15% or less of the fund’s net assets. Simply, a fund cannot have more than 15% of holdings in assets that cannot be converted to cash within seven days. Mutual fund companies must pay the proceeds of the redemption amount to the investor within seven calendar days but typically pay in three days or less. For most investors, if they place a sell order on a mutual fund with a broker/dealer prior to 4:00 p.m. EST, the fund will usually redeem their order the same day. Then there is a one-to-two-day settlement period before the investor actually receives the funds in their account. This rule is called Rule 15c6-1(a) under the Securities and Exchange Act.
Along with the settlement rule and the 15% guideline, Rule 22c1 is another rule that mutual funds abide by. This rule is called the “forward pricing” rule, which requires funds and their principle underwriters to sell and redeem fund shares based on the fund’s net asset value.
SEC has also released rules for use of swing pricing by mutual funds. Click here to learn more about swing pricing.
The “Final Rule” Rule 22e-4
The new ruling says that all mutual funds, but not money market funds, will be required to have a written liquidity risk management program with several required elements. This program must be run at least on an annual basis and the assessment must use the same factors on a consistent basis. This assessment must show the fund’s strategy and liquidity of portfolio assets in both normal and stressed scenarios, demonstrating that the fund can support a need for mass amounts of liquidity. Funds should also be able to project their cash flows for both the short and the long term, as well as have a defined amount of cash on hand for both scenarios.
The next mandate the rule states is that each fund must review its classification of liquidity within its portfolio on at least a monthly basis. There are four categories each investment will fall under – highly liquid, moderately liquid, less liquid and illiquid. The highly liquid investments are convertible to cash within three business days, the moderately liquid are within three to seven and the less liquid within seven days. Illiquid investments are not saleable within seven calendar days.
The rule also dictates that each fund will determine its own highly liquid investment minimum. The required minimum amount will be specified as a percentage of the fund’s net assets to be invested in highly liquid, cash-type investments that can be converted to cash within three business days or less. However, in the case of a need for liquidity, these funds do not necessarily need to be the first to be accessed and are more considered a “rainy day” account. A fund may also breach its own minimum requirement, so long as it reports it to the SEC using the form N-LIQUID with the corresponding fund board reporting.
Similar to the 15% guideline that funds were already abiding by, the rule also states that a fund cannot have more than 15% of its NAV invested in illiquid investments. The fund would also have to issue the same N-LIQUID form to notify the SEC. However, the rule states that if a fund’s holdings were to grow above the 15% threshold, it does not have to divest to meet the requirements.
Finally, the rule states that the board of directors of the fund are to serve as an oversight committee when implementing and reviewing the liquidity risk management program. The fund must obtain the board’s written approval of its liquidity risk management program before it can be implemented and submitted to the SEC. The fund would also need the board’s approval to make any material changes to the risk management program as well. The board is also required to receive breach reports, where the fund either broke its highly liquid or illiquid thresholds.
Public Disclosure and Confidential Reporting Requirements
The new rule has several reporting requirements with which each fund must comply. Form N-1A requires a fund to disclose in its prospectus the number of days it will take for a redeeming investor to be paid.
The N-PORT form requires funds to file electronically with the SEC the monthly portfolio investment information. In this report is a breakdown of each fund, categorized into the four levels of liquidity. These submissions will be done monthly and the information will not be available to the public until 60 days after the end of the third month of the fund’s fiscal quarter. However, liquidity information on any fund’s highly liquid investment minimum will be treated as confidential by the SEC.
The N-CEN form is the filing that is required on an annual basis and acts as a census to the fund. The form asks questions like the fund’s line of credits, interfund lending and interfund borrowing, all of which would be relevant to the fund’s overall liquidity position.
Larger entities that have net assets of over $1 billion must be in complaince of the new rule as of December 1, 2018. Funds that are smaller will need to be in compliance by June 1, 2019.
The Bottom Line
Overall, the new rule should be a benefit for investors and provide them with some safety from liquidity risk when it comes to mutual fund investing. These rules are similar to that of the stress tests that are done on the major banks, ensuring that each have a certain level of liquidity and capital. If a fund sees a sudden influx of redemptions, these new rules should help prepare it for such an occasion so that neither the fund nor its shareholders are negatively affected.
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