This is my second attempt at the second in my series of posts analyzing the SEC’s recent proposal to require money market funds with floating share prices (“institutional money funds”) to implement “swing pricing” for pricing periods in which the fund has net redemptions. I removed some earlier posts because I am less sure how to interpret the proposed definition of a “swing factor.” This post explores the disparity between the proposed definition of a “swing factor” and the discussion of swing pricing in the proposing release.
What Is the Swing Factor a Percentage of?
The proposed amendments would define the “swing factor” as “the amount, expressed as a percentage of the fund’s net asset value …, by which a fund adjusts its net asset value per share.” The swing factor must be based on a good faith estimate of the costs of selling a vertical slice of the fund’s portfolio equal to the net redemptions, which will be a dollar amount of costs. The proposed amendments to not state how a fund should translate this dollar amount into a percentage of its net asset value per share (“NAV”).
Taken literally (as I did initially) the definition would divide the costs by “the fund’s net asset value.” This would spread the costs across all the fund’s shares, so that redeeming shareholders would bear only a pro rata share of the costs. This version of swing pricing would differ from an ordinary NAV only by subtracting estimated costs from the net assets before they are incurred, rather than subtracting actual costs once they have been booked, which typically happens the day after the redemption.
The net assets of institutional money funds range from hundreds of millions to over $70 billion. One basis point of a hundred million dollars is $10,000, so it would require costs of tens or hundreds of thousands of dollars before a swing factor calculated in this manner could change an institutional money fund’s four digit NAV. A fund would rarely determine a swing price that differs from its NAV using this approach.
An Alternative Approach
There are at least two aspects of the proposing release that are inconsistent with my initial interpretation. First, the proposing release describes swing pricing as:
a process of adjusting a fund’s current NAV such that the transaction price effectively passes on costs stemming from shareholder transaction flows out of the fund to shareholders associated with that activity.”
To achieve this result, the fund must withhold the full amount (rather than a pro rata share) of these costs from the net redemptions paid to the redeeming shareholders.
Second, the proposing release repeatedly claims that:
adjusting the NAV by the spread costs of redemptions is economically equivalent to striking the NAV at the bid price ….”
The “spread cost” is the cost of selling at their bid prices a vertical slice of the fund’s portfolio equal to the net redemptions, assuming that the fund values its portfolio at the “mid” between the bid and asked prices. Valuing a percentage of the portfolio at the bid price and dividing it by a fund’s total net assets would not be the “economic equivalent” of valuing the whole portfolio at the bid price. Instead, the cost must be divided by the same percentage as the vertical slice, namely the net redemptions as a percentage of the net assets.
This would mean that swing pricing requires a two-step process: first, the fund must divide its total assets by its outstanding shares to calculate its NAV; second, it must divide the estimated cost by the net redemptions to calculate the swing factor. The swing price is the NAV reduced by the swing factor, which makes the swing price a value per redeemed share. The non-redeemed shares continue to be valued at their NAV.
An Intuitive Example
I find it easier to think of this process in terms of shares rather than share prices. Assume that a fund must pay out $5 million for net redemptions and the estimated costs of selling a $5 million vertical slice of the portfolio is $1,000. To pass the costs onto the redeeming shareholders, a fund with a $1.000 NAV would redeem from these shareholders 5 million shares to cover the net redemptions and another 1000 of their shares to reimburse itself for the costs. Payment of the net redemptions and costs would reduce the fund’s net asset value by $5,001,000, which matches the 5,001,000 reduction in outstanding shares, leaving the NAV at $1.000. The “swing price” is the price implied when redeeming 5,001,000 shares but paying out only $5 million: $5,000,000 ÷ 5,001,000 = $0.99980004, which rounds to $0.9998. This approach, unlike my initial approach, requires only a relatively small cost to produce a swing price below the fund’s NAV.
If I am correct that this is the intended means of determining a “swing factor,” the SEC should clarify this and provide an example in the final release.