Is the price right? Swing pricing and investor redemptions
BIS Working Papers No 664
How can mutual funds manage the liquidity risks they are exposed to? We study funds' use of swing pricing, an innovative liquidity management tool, which is being allowed in a growing number of jurisdictions and will be introduced in the United States in 2018.
Investment in mutual funds has been growing at an exceptional pace over the past few years, with possible implications for financial stability. This warrants increased attention on how funds manage risks. For open-end mutual funds, a key risk stems from unexpected redemptions: Investors can redeem their fund shares at short notice, which may force the fund to sell assets. Yet these assets can be difficult to liquidate, particularly under stressed market conditions. We assess how funds can manage this risk using "swing pricing". Swing pricing allows a fund to reduce the payout to investors when redemptions are large. This, in principle, discourages investors from selling out at short notice - but little is known about how effective the tool is in practice.
We assess the effects of swing pricing by comparing open-end bond funds in Luxembourg, where swing pricing is allowed, with similar funds in the United States, where it is not. We find that, during normal times, flows out of Luxembourg funds are less sensitive to bad fund performance than those out of US funds not using swing pricing. This tallies with the expected impact of swing pricing on investor incentives. Yet during periods of market stress, such as the 2013 US taper tantrum, we find no such effect. One possible reason is that funds do not use the tool enough to discourage withdrawals during times of stress. We also show that Luxembourg funds benefited from higher returns during the taper tantrum, as expected, although prices were more volatile. In addition, we find that Luxembourg funds tend to hold less cash than their US counterparts, since swing pricing acts as a substitute for maintaining high reserves. This reduces the stabilising effect of swing pricing, but regulators could offset this through other measures.
How effective are available policy tools in managing liquidity risks in the mutual fund industry? We assess one such tool - swing pricing - which allows funds to adjust their settlement price in response to large net flows. Our empirical analysis exploits the fact that swing pricing is available to Luxembourg funds, but not yet to U.S. funds. We show that swing pricing dampens outflows in reaction to weak fund performance, but has a limited effect during stress episodes. Furthermore, swing pricing supports fund returns, while raising accounting volatility, and may lead to lower cash buffers.
JEL classification: G01, G23, G28, C72
Keywords: Financial stability, mutual funds, regulation, market liquidity