This is another in my series of posts on the SEC’s proposal to require that money market funds with floating net asset values (“institutional money funds”) implement swing pricing during any pricing period in which the fund has net redemptions. This post continues the analysis of the estimated costs that an institutional money fund “must include, for each security in the fund’s portfolio” when determining any swing price. These costs are:
- Spread costs,
- Brokerage commissions,
- Custody fees, and
- Any other charges, fees, and taxes associated with portfolio security sales.
I cannot tell what this last bullet might include, so I will discuss two expenses that should not be included.
What Is Included?
As with custody fees, the proposing release does not explain what would be included in “other charges, fees, and taxes.” I have not encountered a transaction related expense in connection with selling money market instruments such as negotiable certificates of deposit (“CDs”). Perhaps an early withdrawal fee for a non-negotiable CD might provide an example. This is clearly a “catch-all,” but it would help if the SEC indicated what it’s intended to catch in any adopting release.
Capital Gains Taxes Should Not Be Included
Given the reference to “taxes,” it is tempting to think that, if the sale of a vertical slice of the portfolio resulted in net capital gains, the taxes on these gains would be “associated with portfolio security sales.” However, the proposed amendments would require a swing price to be based on “estimates, …, of the costs the fund would incur ….” Every money fund I have ever worked with elects to be treated as a “regulated investment company” under Subchapter M of the Internal Revenue Code. Subchapter M permits a regulated investment company, unlike other taxable corporations, to deduct from its income dividends (including dividends of capital gains) paid to shareholders. So long as a fund annually distributes all its net income and net gains to shareholders, as is nearly always the case, it should not incur any taxes as a result of selling portfolio securities.
I also do not see any need to compensate a fund’s remaining shareholders for any capital gains tax they might pay, as they were going to pay this tax in any event. Generally, a money market instrument can be sold at a gain only if its yield exceeds current market rates for instruments of that type and tenor. The gain should equal the present value of this excess yield. If the instrument had not been sold, shareholders would have received the entire yield as dividends and paid taxes on these dividends. So, selling the instrument at a gain does not generate a new tax liability; it affects only the timing of when shareholders are taxed. As the portfolios of institutional prime money funds typically have weighted average lives of less than 60 days, gains will generally be taxed in the same year as the yield would have been taxed if the instrument had not been sold, so the capital gains should not impact even the timing of the shareholders’ tax liabilities.
Transfer Agency Fees Should Not Be Included
On the other hand, a fund will incur transfer agency fees as a result of redemptions. Transfer agents typically charge funds, as part of their compensation, fees based on the number of orders and wire transfers processed. The greater the number of redemption orders and wire payments, the higher these fees would be.
However, such transfer agency fees are not “associated with portfolio security sales.” It would also be inappropriate to treat the fees charged for redemptions differently from those charged for subscriptions and exchanges. Ultimately, the amount of transaction fees charged by the transfer agent depends on the total amount of orders and wires processed rather than whether the fund had net subscriptions or redemptions during a pricing period.
On to Market Impacts
Having canvased the estimated expenses institutional money funds “must include” in their swing prices, we move onto the estimation of market impact factors that funds must add when net redemptions exceed the market impact threshold. I believe this will be challenging for money funds that do not regularly sell their investments, and my next post will explain why this may be the case.