Market regulator Securities and Exchange Board of India (SEBI) has proposed a swing-pricing mechanism to protect mutual fund (MF) investors in the event market dislocation. Swing pricing mechanism shall be initially mandated only for all open-ended debt schemes that have high or very high risk on risk-o-meter.
Swing pricing will allow fund houses to adjust a scheme’s net asset value (NAV) in response to inflows and outflows, protecting long-term unit-holders from value erosion during a phase of heavy redemptions or liquidity-crunch periods. It is a potential risk-mitigation measure for products, which have inherent liquidity risk.
When large sudden, untimely opportunistic money flows in or out of a scheme, it can often adversely impact other existing retail investors.
The move comes as part of reform measures being rolled out in the wake of Franklin Templeton MF’s winding up of six debt funds in April 2020.
As per the swing pricing mechanism, if the net inflows are more than the swing threshold, NAV will be adjusted upwards and if net outflows are more than the swing threshold, the NAV will be adjusted downwards.
When swing pricing mechanism is triggered and swing factor is made applicable (during normal time or market dislocation, as the case may be), both the entering and exiting investors would get NAV adjusted for swing pricing.
While releasing a consultation paper on swing pricing mechanism, SEBI said that it has considered regulatory practices followed by other jurisdictions. The regulator has proposed a hybrid model, which is partial swing during normal times and a mandatory full swing during times of market dislocation.
SEBI will ascertain ‘market dislocation’ either based on the recommendation from Association of Mutual Funds in India's (AMFI’s) or based on a combination of various factors like net redemption build up at industry level, global market indicators, Indian market indicators as well as bond market indicators.
“There is a need for a mechanism that imposes certain costs on existing investors (since they are contributing to a downward spiral in NAV) while incentivising entering investors (since they are helping to stem the downward spiral in NAV). This happens as the NAV is adjusted downwards during times when net outflows are more than the swing threshold and this lower NAV is offered to the entering investors during such times,” SEBI said in its consultation paper.
“During market dislocation, applicability of minimum swing factor will be as stipulated by SEBI, which shall be risk-based. Beyond this, the asset management company (AMC) can choose to levy higher swing factor if it considers such a factor to be in the best and equitable interest of its unit-holders," the consultation paper added.
The regulator has also proposed a minimum swing factor of 1% to 2% for open-ended debt schemes based on their risk profile.
‘Swing factor’ is a cost that the exiting investor must pay. It is applied as a percentage of the investor’s holding in the fund as a deterrent for large investors to stop them from pulling out in a hurry.
When the swing factor is applied, both the entering and exiting investors will ideally get NAV adjusted for swing pricing.
Swing pricing model should be implemented in a phased manner. In the first phase, it will be mandated only during the times of outflow market dislocation across mutual funds as it is a high-risk scenario. It is proposed that partial swing will be adopted during normal times, mandatory full swing during times of market dislocation.
Applicability of swing pricing will be optional based on a predetermined minimum swing threshold and maximum swing factor. However, during market dislocation, all schemes to give effect to swing pricing; certain minimum uniform swing factors to apply across industry.
During subsequent phases, it is proposed that SEBI will examine the applicability of swing pricing mechanism to equity schemes, hybrid schemes, solution-oriented schemes and other schemes like index funds and exchange traded funds (ETFs).
Swing pricing shall be made applicable to all unit-holders with an exemption for redemptions up to Rs2 lakh for all unit-holders and up to Rs5 lakh for senior citizens at mutual fund level in order to keep retail investor and senior citizen insulated from the applicability of swing pricing to certain extent.
If large transactions still go through, the fund house would be able to pass on costs of the sudden flows to the investor responsible rather than to existing investors.
Market experts highlight that the swing pricing mechanism will protect existing small investors in a debt scheme in case there are large outflows which can potentially disrupt the portfolio.
The cost of such transactions will be borne by the redeeming investors rather than existing investors.