SEC Rule 22e-4 and Swing Pricing Ruling: Impact Analysis
In contrast to the externally imposed regulatory standards in the insurance and banking industries, investment risk management requirements for investment companies had been largely self-imposed until last October, when the SEC voted to adopt rules to modernize reporting and disclosure of information. This move is meant to enhance liquidity risk management of open-end funds.
These landmark SEC rulings will not only shape risk management practice in investment companies, but also will have profound and long-term effects on the investment management industry at large.
Investment Strategies and Investment Vehicles
With SEC Rule 22e-4, managers are now required to consider whether an investment strategy is appropriate for an open-end fund. This requirement expressly addresses the paradoxical asset-liability liquidity mismatch of open-end funds that use less liquid assets. While established fund families with a competitive advantage in investment strategy, management, and operations may decide to remain in the game, marginal firms will likely find the cost of maintaining compliance with Rule 22e-4 economically prohibitive.
Therefore, investment strategies covering less liquid asset classes or segments are expected to move from open-end to other structures such as hedge funds—where, arguably, these strategies actually belong. Meanwhile, long-term institutional investors with more predictable liquidity needs, such as pensions and endowments, will likely allocate more capital into these assets and segments to take advantage of higher premiums demanded by open-end funds.
Market Stability and Investor Behavior
While the main purpose of Rule 22e-4 is to protect investors in open-end funds, the SEC certainly had a larger purpose, as stated in the Rule itself: “There is also a potential for adverse effects on the markets […] such liquidity stress on the assets held in the fund has the potential to transmit stress to other funds or portions of the market as well” (p. 34).
In addition, changes in the investment management industry triggered by SEC Rule 22e-4 and related regulations, such as the swing pricing rule (SEC amendments to 22c-1 of 1940 ACT), will remove incentives for first-movers and will discourage investors’ “animal spirit” and gaming behavior with respect to fund investing.
Investment Risk Management Practice
While several years behind its European counterparts, SEC's Rule 22e-4 formalizes a long-established risk management practice within investment companies of giving primacy to liquidity risk over other types of investment risks like market risk.
Firms need to devise optimal liquidity risk management programs for their investment processes, tailored to funds’ strategies, underlying investments, investor types, and behavioral patterns. For example, some funds employing risk allocation/budgeting in their portfolio construction and rebalancing processes may choose to incorporate liquidity as a constraint, whereas others may opt to deal with liquidity risks only in ex-post compliance reporting.
Performance Measurement and Attribution
Liquidity risk management programs may introduce certain complications when interpreting performance results, performance attribution, and risk attribution (e.g., tracking error decomposition). For open-end funds using less liquid assets, deviations from fund benchmarks will not be driven purely by investment strategy but also in part by liquidity constraints. Therefore, managers’ results with these funds are not directly comparable to those of investment managers operating outside of open-end funds.
The final versions of Rule 22e-4 and related rules been applauded and embraced by the industry, and will continue to shape risk management programs in fund management companies. The CFA Institute and its charterholders actively participated in the SEC review and commentary process. The body of knowledge of investment risk management, and its related CFA core curriculum, will undoubtedly be enriched by practitioners in the years to come.
About the Author
Bai Gu, CFA, is an independent consultant working for investment management firms in the areas of performance, attribution, and risk management. Previously, Bai held various positions at Smith Breeden Associates, Robeco USA, Morgan Stanley & Co., and KPMG Consulting.