The concept of liquidity is a very important topic in finance. Liquidity is a financial term that describes how quickly an asset can be sold and converted into cash, without affecting the price of that asset. An asset that is more easily converted into cash in a quicker period of time, without materially affecting the price of that security, is known as more liquid than other assets.
For example, one of the benefits of investing in the stock market is that stocks are highly liquid. It takes only a matter of minutes and a few mouse clicks to buy and sell stocks. As a result, stocks are highly liquid, because an investor can turn their shares into cash very quickly.
The Securities and Exchange Commission has proposed new rules designed to enhance liquidity for investors as it pertains to the mutual fund industry. Here is a rundown of the new rules, and why they matter for investors.
How the New SEC Measures Will Affect Mutual Funds
The SEC has proposed a set of new rules regarding liquidity of open-ended funds, such as mutual funds. Under the proposed changes, open-ended funds will be required to place liquidity risk management tools into practice. In addition, the SEC wants open-ended funds to improve their disclosure practices regarding fund liquidity and redemption policies.
The proposed changes also include language on what is called “swing pricing,” a tactic used to pass on costs of liquidation and redemptions directly to shareholders. This measure is designed to protect existing fund holders from dilution caused by other shareholders’ purchases and redemptions.
Moreover, the proposed rules would require mutual funds to have a liquidity risk management program. There are many key aspects of this program that fund holders should know about. First, open-ended funds would have to classify each position according to its liquidity. Then, they would have to determine a minimum percentage of its assets that must be invested in cash, otherwise in assets that can be converted into cash within three business days. The Board would then be responsible for reviewing the fund to make sure it meets these requirements.
The Bottom Line
These proposed changes are important because they have the potential to enhance liquidity for mutual funds, which are traditionally less liquid than many other forms of investment. The reason for that is largely due to how mutual funds are priced. Unlike exchange-traded funds, which are traded throughout the day, mutual funds are priced and traded once, at the end of the day. Investors who want to buy or sell a mutual fund do not receive consistent pricing throughout the day. They can only submit orders, and then have to wait until the end of the day to find out what price they received.
Liquidity is one of the main reasons why exchange traded funds have become increasingly popular in recent years. ETFs give the investor the same benefits of a mutual fund, in that they invest in a basket of securities, but with the added benefit of higher liquidity than traditional mutual funds. As a result, enhancing liquidity for mutual funds could place mutual funds on more even ground with ETFs.