The market regulator Securities and Exchange Board of India (SEBI) has asked fund houses to implement swing pricing in most open-ended debt funds from March 2022.
Here are the details of the mechanism.
What is swing pricing?
Swing pricing is an adjustment made to the published Net Asset Value or NAV of a mutual fund during extreme circumstances. During a liquidity crunch or in reaction to specific events, large investors in debt funds may pull out their money. When this happens, existing investors get adversely impacted as good-quality liquid securities would have to be sold to meet redemption requests. So, the proportion of illiquid securities in the portfolio rises. SEBI has now mandated that such large outflows happen at a price that is 1-2 percent below the current NAV.
What problem does it seek to address?
In situations where market liquidity dries up temporarily or there are stressed securities in a mutual fund portfolio, swing pricing can be used. It is like an exit load if investors want to make large withdrawals during market dislocations or liquidity issues. The objective here is to pass on any additional transaction costs arising from large outflows to the ones redeeming rather than the staying investors.
What did SEBI announce?
SEBI has asked the Association of Mutual Funds of India (AMFI) to makes its suggestions about the key parameters and triggers. This will be applicable for high-risk open-ended schemes in scenarios of net outflows.
The applicability of swing pricing under normal market conditions is optional for asset managers. However, the criteria and parameters that determine the applicability of swing pricing need to be included in the scheme information document (SID) beforehand. Details such as the threshold for triggering swing pricing, the range and other broad parameters are sought to be prescribed by AMFI. Apart from what AMFI prescribes, AMCs can have their own criteria as well.
For conditions of market dislocation, swing pricing can be applied on open ended debt schemes with high or very high risk, as per SEBI’s risk o meter. Overnight, Gilt and 10-year maturity Gilt funds are not included in this framework.
The SEBI circular defines the minimum swing pricing in case of debt funds with pre-determined risk criteria. For example, in schemes where both duration risk and credit risk are low, the swing factor is optional. On the other hand, in schemes that have high duration and credit risks, the minimum swing factor to be used is 2 percent. Based on duration and credit risk, SEBI has suggested minimum swing factor for nine different combinations, of which three have an optional swing factor and for the other six minimum swing factor ranges from 1-2 percent.
Once a swing factor has been applied to the NAV, you will have to trade units at the adjusted NAV.
Why was it adopted?
The debt fund crisis that started with IL&FS in 2018 and subsequent defaults by large corporates were starting points. The Franklin Templeton episode, with the fund house suddenly winding up six debt schemes due to the COVID-19 disruption worsened the situation.
Investigations by SEBI later found that large-sized redemptions were made by insiders a week prior to the official announcement of winding up.
Typically, informed investors, be they high net worth individuals or institutions manage to exit, even as retail investors get left behind with a portfolio of illiquid securities. A swing factor applied on the NAV protects retail investors from bearing the brunt of a fall in NAV due to such exits.
How does it help?
The SEBI circular allows redemptions up to Rs 2 lakh for each mutual fund scheme, whether it is in normal times or in times of market dislocation. This means that smaller retail investors will remain unaffected by NAV changes resulting from sudden large-sized outflows in times of adversity. The swing pricing mechanism can also act as a deterrent for large-sized redemptions from investors.
Does it solve all problems?
The problem it does not solve is of investors being left behind with an illiquid portfolio if these large sized redemptions do happen even after a swing factor is applied. A swing factor adjusted NAV will not make the portfolio quality better or prevent the adverse impact of holding illiquid securities.
The criteria and parameters for triggering swing pricing should be standardised by AMFI, with little ambiguity.
Communication around application of swing pricing on days of market dislocation needs to be timely for it to be effective. It’s unclear whether SEBI or AMFI will be responsible for this communication.
The range of swing pricing may be a cause for concern for asset managers during a low interest rate environment, when debt fund yields are relatively lower. The minimum swing pricing adjustment is given as 2 percent for high-risk categories, which can be a huge penalty if the annual yield of the scheme itself is in the range of only 7-8 percent.