Fund providers continue to establish policies designed to protect their shareholders from potentially harmful activity. One particular area of interest to fund companies is the impact of trading costs and fees.

Significant buying and selling activity within a fund can result in excessive fees that destroy shareholder value. In this article, we’ll introduce the concept of swing pricing and how it is used by funds to try to address this issue.

Swing pricing occurs when a fund provider adjusts the net asset value (NAV) of a fund in order to pass on the costs of trading to those that are buying and selling within their accounts. It’s designed to protect longer-term shareholders from having the value of their accounts eroded by the transaction activity of others within the same fund.

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Swing pricing is implemented if a fund’s net inflows or outflows exceed a preset level as determined by the fund provider. In all instances, the provider calculates the NAV as normal before adjusting it by the designated swing factor.

Here’s a simple example: XYZ Fund has a price of $20 per share and the fund’s provider sets a swing factor of 0.1% of the NAV for net flows above or below 5% of the prior day’s price. If the fund experiences a net inflow of 10% of NAV, the price of the fund would be adjusted upward to $20.02 ($20 + ($20 * 0.1%)). The same situation would occur with a 10% outflow except that the price would be adjusted downward to $19.98. If a net flow of less than 10% occurs, swing pricing is not implemented and the fund’s price remains at $20.

In order to understand how NAV is determined, check here.

Swing pricing is not the same as fair value pricing, and it’s easy to get the two terms confused. Here are two major differences:

• With fair value pricing, a security’s price is adjusted to an estimated current value if the most recently traded price is considered out of date or stale. On the contrary, swing pricing adjusts the NAV of the fund to account for the costs of high volume buying or selling.
• Fair value pricing occurs at the security level, whereas swing pricing occurs at the portfolio level.

Most open-end funds are eligible to use swing pricing with a few exceptions. Money market funds are ineligible since they have significant safeguards in place already to address liquidity concerns that essentially accomplish the same goal as swing pricing. ETFs and closed-end funds are also ineligible as they are traded as baskets of securities between traders and don’t necessarily need to buy or sell shares in order to facilitate shareholder activity.

Swing pricing is an optional strategy for fund providers to use and can be applied on an individual fund basis. Whether or not swing pricing is implemented and whether full or partial swing pricing is used is the decision of the fund provider. Under rule 22c-2 of the Investment Company Act, the SEC provides discretion for fund boards to structure fees in a way that is appropriate for achieving anti-dilution goals. Swing pricing may be used for certain funds but not others.

To learn more about SEC’s rules to enhance the liquidity of open-end funds, check out our news article on SEC’s New Liquidity Management Rules.

Under ordinary circumstances, trading costs and fees typically come right out of the fund’s total net assets and are, therefore, spread across all shareholders. Swing pricing helps assure that the larger costs of significant inflows or outflows are passed on to the appropriate individuals responsible for the trading activity. Long-term buy-and-hold shareholders aren’t materially impacted by these trading costs, thus protecting the value of their investments.

While swing pricing has generally been an effective tool, it may not cover all liquidity scenarios adequately. Swing pricing only applies a percentage factor to larger flows. In the event of a significant liquidity crunch, the swing factor may not necessarily cover all transaction-related costs. In this situation, long-term shareholders may still be impacted by these trading fees.

When a partial swing pricing method is used, large flows could still occur that may not be large enough to initiate the swing pricing process. Again, long-term shareholders may feel some minor impact. Therefore, swing pricing policy needs to be monitored and reassessed on a continuous basis to ensure it remains effective.

Funds can implement a full swing or partial swing methodology. With full swing, the NAV of the fund is adjusted every trading day for the net asset change regardless of how large or small it is. With partial swing, the NAV is only adjusted if the predetermined threshold is reached. The example used earlier would be an example of partial swing pricing.

The SEC has established a number of legal forms that fund companies are required to complete in order to disclose and report changes to their swing pricing policies, including Forms N1-A and N-CEN. Regulation S-X, the regulation that details the required content and format of financial reports, has also been amended to improve swing pricing disclosures.

While many larger financial institutions already have documented swing pricing policies in place, compliance dates have been pushed back to 2018 in order to allow smaller companies to get all the necessary infrastructure in place to comply with SEC requirements.

To familiarize yourself with regulations governing the mutual fund industry, read about the Investment Company Act of 1940.

The SEC continues to implement policies designed to protect shareholders and guide the liquidity needs of funds. Swing pricing has largely become an effective tool in assigning larger trading costs to those entities responsible for them. It also helps direct fund companies in how to best handle large net asset flows to ensure that nobody involved becomes materially harmed in the event of unusual activity.

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