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SEBI wants to Swing

In this week's FinMail, we simplify Swing Price Mechanism, SEBI's shield to protect long term mutual fund investors from traders and Insiders.

The Story:

SEBI on 19th July published a consultation paper on its website asking views and opinions from the public and the stakeholders of the mutual fund industry about the introduction of a Swing Pricing Mechanism for adjusting a mutual fund's NAV.

SEBI has further discussed in the paper that the swing price mechanism ensures that all types of investors are treated fairly in a fund and it reduces the effect of frequent activity in a fund by passing on the charges to the transaction maker.

What is this Swing Price Mechanism, why it was needed? What changes and advantages will it have, all about this in this FinMail.

A quick disclaimer before we start, Swing Price Mechanism is a complex thing and it might require you to relook the explanation to understand this concept. We have tried to simplify Swing Pricing as basic as we could, so we suggest you to take your morning tea/coffee shot ready while reading this one ;) and keep it slow. Thanks! Let's start right away.

Before we deep dive into the 'Swing Price mechanism', we need to understand the basics which will help you understand it better and that is Fund NAV (Net Asset Value). So let's first understand 'Fund NAV'.

Breaking Down Fund NAV:

Let's say there's this equity mutual fund that has 3 Investors - Raju, Babu, and Shyam(No, this is not a mutual fund jo 21 din me paisa double karega). They are the only initial investors in the mutual fund and have invested at the base price of ₹10 per unit. Raju invests ₹30,000 and Babu and Shyam invest ₹10,000 each. The total fund collected is ₹50,000 and thus the total number of units will be 5000.00 @ ₹10/- per unit. The fund manager then invests this money and purchases 10 shares of Infosys @ ₹1600, 100 shares of Tata Power @ ₹125, 20 shares of Gujarat Gas @ ₹750 and keeps the remaining ₹6500 in cash.

That is what the initial NAV breakup looks like, but as the days will pass, there would be an increase/decrease in asset value, inflows/redemptions as well. So, accordingly, there would be a change in fund NAV as well. There is also a fund expense ratio of 1% that the mutual fund charges for managing Investor's money and thus it would also impact the fund NAV. Let's understand this change as well. Now let's say, on the next day the stock price of Infosys rose by 2%, Tata Power by 5% and Gujarat Gas drops by 1%. Taking all the factors into account, here's the effect.

The fund NAV changes every day and every teeny-tiny element is adjusted in the NAV. Even if an Investor redeems or invests money, the NAV changes accordingly.

Coming back at our trio, the reason the fund manager has kept some cash holdings in an equity fund is to tackle the frequent redemptions and inflows. Why so? Now let's suppose Raju decides to redeem ₹5,000 from his total investment. So, in case, if the fund did not have sufficient cash, the fund manager would've had to redeem some equity holdings and pay Raju his money. This would have meant that the fund manager had to arrange cash by selling the securities which were bought with an intention of holding them for a long term. Thus, it will affect the future returns of the funds and that of the remaining investors.

But what would happen if there are redemptions that exceed even the cash holdings? For understanding the problem of larger than expected redemptions, consider the story of Franklin Templeton's 6 debt funds that were shut down last year in April. Due to the lockdown, the markets saw large amounts of outflows and even debt funds saw outflows as people had their emergency or liquid funds parked there. FT's 6 debt schemes saw a huge number of redemptions due to which they had to shut down the funds to "protect" the investor's money.

And this problem is not limited to only redemptions, even large inflows create imbalance and necessary steps are taken to ensure no loss happens to the existing investors. The best example, in this case, would be heavy inflows in Small-Cap funds due to which many Small Cap Mutual Funds have stopped accepting fresh funds.

Any type of activity that is unusual than expected affects the fund and the investors within. This damage could be in terms of loss of potential returns, extra brokerages, extra tax, and extra charges/fees. And that's just not it, in a worst-case scenario, it can also result in fund shutdowns like what happened with Franklin Templeton. Unusual heavy withdrawal requests force fund managers to sell off their most liquid securities in order to arrange cash as quickly as possible and thereafter lesser liquid ones and so on. And as the withdrawals extend, the fund and the investors within are left with the least liquid securities which could either be sold on heavy discounts (losses) or either waiting for an ideal time to sold such securities. And that's kind of unfair to the investors who stayed on (retailers mostly), isn't it?

Why should genuine & long-term investors bear the cost of short-term investors investing/redeeming frequently and adding to the charges thereby reducing the overall return? And why should some large investors have an advantage over other investors?

These were some questions that surrounded the market and the Franklin Templeton fiasco fueled the need to have a system in place that would discourage/stop/reduce the activities of some selected investors that hurt other investors in the fund. And thus, here we are, SEBI considering Swing Price Mechanism for NAV of Mutual Funds.

But what exactly Swing Price Mechanism?

SEBI refers to Swing Price Mechanism as, "Swing pricing refers to a process for adjusting a fund’s NAV to effectively pass on transaction costs stemming from net capital activity (i.e., flows into or out of the fund) to the investors associated with that activity during the life of a fund, excluding ramp-up period or termination."

Jabba? Jabba?

Don't worry, we will simplify it for you.

Swing Price Mechanism is an activity to adjust the fund NAV by adding/subtracting a fixed cost to the fund's NAV. Swing Pricing aims to add costs to the fund NAV or reduce the fund NAV in order to discourage more inflows/outflows. Interestingly, the adjusted NAV doesn't affect the existing investors but only the one's who exit or invest.

Swing Pricing works in two ways: Full Swing and Partial Swing. Under the Full Swing mechanism, the fund NAV is always adjusted as per the swing rate and added/deducted from the fund NAV. While under the Partial Swing approach, the swing triggers after meeting certain conditions after which the fund NAV is adjusted as per the swing rate. SEBI in India wants to introduce Partial Swing, so let's understand Partial Swing through an example.

Partial Swing as mentioned triggers after some conditions are met. But what exactly are those conditions aka 'The Threshold limit'?

Let's take the same example of our Hera Pheri trio. As we know the fund size was ₹50,000. The fund manager has set a threshold limit, that in the case when the total inflows/outflows exceed 5% of the fund size in a single day, the fund NAV would be adjusted upwards/downwards at an extra 2%. Now let's say Raju and Babu redeem ₹5,000 each from their investment. This means the fund's outflow in a single day has exceeded 5% of the fund size limit, this means that they will get their redemption amount after adjusting NAV by 2%. The latest NAV was ₹10.1590 but their units will get redeemed at ₹9.9558 (even less than the initial NAV)

The same happens when the fund inflows exceed 5% of the total fund. Let's say Anuradha invests ₹20,000 in the fund. Anuradha won't get units at ₹10.1590/- unit but instead the NAV cost would be ₹10.3621. This way large investors who redeem excess units will get lower redemption amounts than their actual amount and large investors investing in excess would have to pay more for the same number of units. The extra costs due to such extra redemptions/investments can be written off from these charges, thereby nullify or reducing the impact of such transactions on existing (long-term) investors.

This existence of a threshold means the fund is applying a Partial Swing Mechanism. SEBI has said that in situations of market dislocation (the ones like the current pandemic) the funds can also impose a complete swing mechanism wherein every transaction would be redeemed/invested at an adjusted NAV. Complete Swing Price mechanism also works the same way wherein every transaction in a fund will be adjusted by the swing rate.

How can Swing Price Mechanism benefit Long Term investors?

As we understood, the investors who suffer the bigger jolts are the investors who stay behind, retail investors.

Swing Price Mechanism will transfer the effect of large transactions to the transaction doer rather than to all the investors. If some investor invests or withdraws an amount greater than the decided threshold amount, the cost-effectiveness of such a large transaction will be borne by the same people rather than all people who have invested in the fund.

By rightly implementing the Swing Price Mechanism, incidents like Franklin Templeton shutting down its debt schemes can be avoided in the future. Or, at least the after-effects of such incidents can be brought down significantly so that it won't affect the retail investors (for whom mutual funds are meant to be).

But a question still remains, if at a certain day a threshold limit is reached and the swing price mechanism is triggered, the retail investors who might have transacted on the same day, would they suffer from the adjusted NAV as well?

The answer is no! SEBI has proposed that retail investors transacting less than ₹2 lakhs a day and senior citizens transacting ₹5 lakh a day in a scheme on the trigger day will not get affected by the Swing adjusted NAV. So basically, only the big whales will get restricted.

Phew, that was a big one.

Now that we understood the basics of Swing Mechanism, (kind of) let us understand the challenges that SEBI and fund houses might face while implementing this one.

Challenges ahead

Discourage the Big Whales:

This mechanism will surely discourage big whales in investing in Mutual Funds as they are the ones with big investment amounts and if they transact a big amount, they might trigger the mechanism and suffer higher costs.

Easy to jump this trigger:

If there's a threshold that will trigger the mechanism it is easy to find a loophole around that. Like if the investor gets to know that the threshold limit is 5% of AUM or so then the big investor might divide the number of transactions in various days and skip the trigger. This is why the threshold must be kept a secret by the fund houses. But also then, who guarantees that the fund houses will not let insiders skip the trigger as it is to be adjusted manually?

No single threshold:

SEBI has left the decision to decide the threshold limit that will trigger the mechanism to the fund houses. While this gives the funds some independence, having multiple thresholds will mean it will be difficult to implement and as thresholds must be kept secret, a genuine big investor might not know which fund to select to decrease cost.

Condition of Market Dislocation:

SEBI has said that the mechanism will also be implemented in Market Dislocations. But there's no fixed line that can draw a difference between market dislocation and market stability. In most of the times, heavy redemptions/investments happen at first and then markets are classified as dislocated.

This concludes the Swing Price mechanism as a concept and its limitations. Before we end the day, let's quickly go through the plans SEBI has with this mechanism.

The Plan

SEBI has currently proposed that it intends to introduce the Swing Price Mechanism in Debt Mutual Funds for the time being. And that too, not all the debt funds but only with a risk-o-meter rating of 'high' to 'very high' risk. SEBI plans to implement this mechanism in phases through which it will implement in debt funds first and closely monitor its success. After which SEBI plans to introduce it in other categories like Equity Mutual Funds, Liquid Funds, Hybrid Funds, etc. It is not that the concept itself is new but it is already being used in countries like US, UK, Luxembourg, Hong Kong, and France and that too successfully, Let's see how the public opinion pans out about SEBI's vision to shield the Mutual Funds once and for all.

That is it for this week's FinMail. Keep learning, stay safe.


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