Swing pricing proves its worth
Once again, it worked to ensure that investors leaving a fund pay for this decision rather than loyal investors. How does the local industry use this tool and are there any potential flaws?
Fund investing is designed for the long term, yet when there is market turbulence some investors become nervous, head for the exit and redeem their holdings. Yet these crisis moments are just when it becomes particularly costly for the fund to sell part of their portfolios, as this is when market liquidity is under particular pressure. Hence it would be unfair that the investors which remain loyal to the fund should bear these costs.
This is where swing pricing comes in – a technique which has become “common market practice” according to the ALFI Swing Pricing survey 2022. This works by charging a fee – a “swing factor” – when an investor redeems their fund share when the asset manager thinks this would be appropriate. More than 80% of asset managers surveyed mentioned that they used swing pricing in previous years.
“The use of swing pricing has grown significantly over the years and Luxembourg was one of the first countries in the world to adopt it,” said Julien Baguet, Director Capital Markets/Financial Risk at Deloitte. The ALFI survey suggested that the choice to not use swing pricing techniques was mainly due to fund or client specific factors. ”We observe a broad use of this anti-dilution technique on large mutual funds with the exception of money market funds,” Baguet noted. No private equity or debt funds included in the ALFI survey used swing pricing, with only one out of 12 real estate funds surveyed doing so. This was explained mostly by low liquidity and many of these funds being “closed-ended”, that is they restrict investors’ ability to redeem.
Full or partial
Funds use either “full swing” or “partial swing” techniques. The former is applied on all redemptions during a given period, while the latter is only implemented after a certain capital activity threshold is reached. According to the ALFI survey, partial swing is by far the most common method, used by around nine in tend managers. “Partial swing has the advantage of focusing only on capital activity that generates material transaction costs for long-term investors, which is in line with the objectives of the methodology,” said Baguet.
The “swing factor” is the charge levied on exiting investors. This is normally a percentage adjustment to the fund’s net asset value. The ALFI survey noted that this was capped at between 2-2.5% for standard UCITS invested in equities and fixed income. Fund of fund products tended to have a factor of around 1%. Funds use a variety of metrics to calculate these figures, including bid-offer spread impacts, transaction costs and associated transaction taxes.
“The systems used by asset servicers to apply swing pricing have become more automated to reduce the risk of error,” said Baguet. “But errors can still happen because swing pricing is not systematically applied.” He commented on market reaction during the most turbulent periods of the COVID-19 and the Ukrainian crises when asset managers applied specific procedures, including more regular reviews being conducted and enhanced communication with clients. “It is key in these times to have strong liquidity modelling capabilities, robust organisational structures and effective controls to avoid issues in the calculation, transmission and application of swing factors or thresholds,” he said.
The ALFI survey indicated that 60% of asset managers reviewed and re-calculated swing factors on a quarterly basis during non-crisis periods. A quarter do this on a monthly basis, with some doing this weekly. A very few look at this only annually while some make a daily assessment. During the market volatility experienced in March and April of 2020, over two thirds of asset managers reviewed swing factors on a daily basis at some point during the crisis period. Three quarters of fund managers have dedicated committees for reviewing swing factors.
While the technique works well, vigilance is required to ensure that it cannot be bypassed. “Asset managers sometimes observe that investors attempt to arbitrage the swing threshold of the partial swing methodology by splitting their orders into smaller ones over a few days,” Baguet noted. Countering this “requires good coordination with the transfer agent processing the investments,” as well as “robust conflict of interest policies, as investors should not be made aware of the level of the thresholds.”