Benjamin King and Jamie Semark
Open-ended funds (OEFs) offer daily redemptions to investors, often while holding illiquid assets that take longer to sell. There is evidence that this mismatch creates an incentive for investors to redeem ahead of others, which could lead to large redemptions from OEFs and asset price falls. Some research has suggested that ‘swing pricing’ can help to moderate these redemptions, but until now, no-one has considered the impact of its use on the wider economy. In a recent paper, we carry out a financial stability cost-benefit analysis of more widespread and consistent usage of swing pricing by OEFs, finding that enhanced swing pricing could reduce amplification of shocks to corporate bond prices, providing benefits to the financial system and economy.
Why are open-ended funds important?
OEFs are pooled investment structures that in the UK are almost all ‘daily dealing’, meaning investors can subscribe to or withdraw from the fund on any given day. Because some OEFs invest in assets that can’t be sold immediately, they have a ‘liquidity mismatch’: their liabilities are more liquid than their assets.
Corporate bond OEFs are important in this context. They are relatively large, often face liquidity mismatch, and can have important effects on the rest of the economy. OEFs are large purchasers of UK corporate bonds, and hold around 17% of UK-issued corporate bonds. And corporate bonds matter for the real economy: changes in bond prices and spreads affect the price at which firms can issue new bonds, and therefore the cost of using corporate bonds to finance investment.
Why do fund pricing rules matter?
Evidence shows that investor flows into, and out of, OEFs are procyclically related to fund returns: when returns are negative investors tend to redeem from OEFs, and when they are positive they tend to invest.
Because OEFs may have to sell assets to pay back investors, these procyclical flows can lead to procyclical selling: as prices fall, OEFs see more outflows and sell more assets, putting more downward pressure on prices. This ends up amplifying shocks to corporate bond spreads.
You might wonder why this is a problem with OEFs – maybe investors would sell assets in a procyclical way even if they held them directly. The answer is that the liquidity mismatch in OEFs creates incentives to withdraw your investment ahead of others. If you redeem from an OEF, you get your investment back at today’s fund value. But if that value doesn’t take into account the costs of trading by the OEF to meet your request, you effectively get free liquidity – and the costs land with other investors in the fund.
This is where ‘swing pricing’ comes in. Swing pricing allows OEF managers to adjust the fund’s price to incorporate the costs of meeting inflows and outflows. For example, if an OEF faces net outflows of £100 which would lead to trading costs of £1 (ie the sum of bid-ask spreads, commissions, taxes and similar for selling £100 of assets is £1) it can swing its price such that redeeming investors receive £99. That should mean redeeming investors have to consider the full costs of their actions.
If that makes flows and sales less procyclical, it should benefit financial stability by reducing the impact of shocks to corporate bond spreads all the way through to GDP growth (Figure 1).
Figure 1: Conceptual framework to assess the benefits of swing pricing
Source: Authors’ calculations.
How effective is swing pricing?
Evidence from the UK and cross-country studies shows that swing pricing can be effective in softening the effect of poor performance on outflows. This effect is large: comparing OEFs with and without swing pricing, the sensitivity of fund outflows to negative performance is about 60% smaller.
UK corporate bond OEFs already use swing pricing, but perhaps not as often or consistently as they should. In a Bank-FCA survey of UK OEFs, about 25% of surveyed OEFs didn’t swing their price at all over 2020 Q1 and Q2 – a period that included the exceptional market volatility of March 2020. And the FPC thought that even where swing pricing had been used, it had not always been applied consistently.
For our baseline estimate of the aggregate impact of enhanced swing pricing in the UK, we scale the 60% figure noted above by the 25% of UK OEFs with no swing pricing usage. This gives us a 15% average reduction in flow-performance sensitivity.
What is the impact of swing pricing on financial markets?
To consider the market impact of procyclical OEF asset sales we use a ‘fund-dealer model’, which includes agents representing various participants (including OEFs) and a market intermediary (dealer). The behaviour of these agents in response to shocks determines how they trade, and whether shocks to corporate bond prices are amplified.
To measure the impact of swing pricing, we run shocks through the model (a) in its baseline setup, and (b) after reducing the parameter that controls how sensitive fund flows are to performance. By making fund flows and asset sales less sensitive to performance, swing pricing leads to reduced amplification of shocks to corporate bond spreads in the model.
In the baseline setup, averaging across the different types of shock, the model suggests that behaviour of agents including OEF investors may amplify an 80 basis point (bp) – one standard deviation – shock to UK investment-grade corporate bonds by around 7bp (with a range depending on the type of shock of 0 to 14bp).
Reducing the OEF flow-performance sensitivity by 15%, the model results suggest swing pricing might reduce amplification of investment-grade corporate bond spreads by around 8%, and by around 22% for high-yield bonds. So, for an 80bp initial shock, investment-grade spreads would instead be amplified by 6bp (Figure 2).
Figure 2: Swing pricing reduces amplification of shocks to corporate bond spreads
Source: Authors’ calculations.
What is the impact of swing pricing on GDP?
To think about how our results map to the economy as a whole, we use a popular summary measure of overall macro risk – GDP-at-risk.
GDP-at-risk uses statistical techniques to estimate the distribution of future GDP growth, based on financial and macroeconomic indicators. This is relevant for financial stability, because it allows us to think about bad but unlikely events. For example, we often think of GDP-at-risk in terms of the severity of a ‘1-in-20’ economic downturn (or in technical terms, the 5th percentile of the conditional GDP growth distribution). So worsening GDP-at-risk means the probability of bad economic outcomes has gone up.
A one standard deviation shock to corporate bond spreads worsens GDP-at-risk (the 5th percentile of cumulative GDP growth) by 1.39% after one year. So after a shock to corporate bond spreads, bad economic outcomes are more likely.
Our previous results show that swing pricing reduces amplification of shocks to corporate bond spreads, so other things equal the spread shocks hitting the economy will be smaller. This is borne out in our results: swing pricing improves GDP-at-risk by 2.2bp, with an estimated range of 0.2 to 7.3bp (Figure 3). Overall our results suggest a modest but relevant potential GDP benefit from enhancing OEFs’ use of swing pricing.
Figure 3: Swing pricing improves the distribution of GDP growth outcomes in the event of a shock to corporate bond spreads
Source: Authors’ calculations.
What are the possible costs of swing pricing?
As we are doing cost-benefit analysis, we also need to consider the potential costs of swing pricing. The main way macroeconomic costs might arise is if reducing liquidity mismatch were to discourage investment in corporate bonds via OEFs.
To think about the possible effect of swing pricing on investment in OEFs, we can imagine two types of OEF investor:
- ‘Fast-moving investors.’ These trade in and out of corporate bond OEFs frequently, and derive a liquidity benefit from the fact that the cost of their trading is borne by remaining investors.
- ‘Slow-moving investors.’ These trade infrequently, and derive no benefit from liquidity mismatch. They do however bear some of the costs by remaining invested in the fund.
Effective swing pricing reduces the liquidity benefit to fast-moving investors from investing in OEFs. They may decide to adjust their portfolios in response, for example selling OEF shares and buying liquid assets. In aggregate this might imply lower demand for corporate bonds, pushing up corporate bond spreads.
However, reducing liquidity mismatch may also increase the average returns provided by corporate bond OEFs. This is because the costs of trading would now be borne by redeeming investors rather than those remaining in the fund, and potentially because OEFs could hold fewer liquid assets (as they will face less volatile outflows). Higher returns are likely to encourage more investment in OEFs from slow-moving investors, and may compensate for some of the lost liquidity for fast-moving investors. These offsetting effects mean the direction of the impact on investment in OEFs is ambiguous.
Conclusion
A growing non-bank sector means more macroprudential actions outside the traditional banking system. Macroprudential authorities will need to be able to weigh up the benefits and costs of these actions. We contribute to this endeavour by assessing the benefits and costs of reducing liquidity mismatch in OEFs, through more widespread and consistent use of swing pricing. Our results suggest that greater use of swing pricing is likely to dampen shocks to corporate bond spreads and improve the distribution of GDP growth, with limited macroeconomic costs.
Benjamin King works in the Bank’s Financial Stability Strategy and Projects Division and Jamie Semark works in the Bank’s Capital Markets Division.
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