While most battles in the passive vs. active conflict have been decided squarely in passive funds’ favour, there’s one arena when active advocates have a fighting chance: the bond markets, where the usual method of market-cap weighted indexing can actually put passive vehicles at a disadvantage.
Even with this advantage, active bond mutual funds still have chinks in their armour — which can be exposed particularly in times of market volatility. “As experienced during the financial crisis of 2008, when market conditions deteriorate, investors may run on funds, causing fire sales and significant market dislocations,” wrote Dunhong Jin and Bige Kahraman of the University of Oxford’s Said Business School, Marcin Kacperczyk of Imperial College London, and Felix Suntheim who’s currently working at the International Monetary Fund (IMF).
In a paper published by the UK’s Financial Conduct Authority (FCA) titled Swing pricing and fragility in open-end mutual funds, the authors explained that the traditional pricing rule for mutual funds affords investors the right to transact their shares at daily-close net asset values (NAV). However, the price a transacting shareholder receives does not account for the corresponding transaction costs that may arise over the multiple business days that elapse as portfolio adjustments are made because of the transaction requests.
“The costs of providing liquidity to transacting shareholders are therefore borne by non-transacting investors in the fund, which dilutes the value of their shares,” they said, noting that the mechanism could give rise to a “first-mover advantage” that creates an incentive to run on funds — an incentive that becomes stronger with illiquid assets, where shareholder transactions impose higher costs.
Recognizing this dilemma, certain industry players have come up with an innovation to change how open-end funds are priced. These alternative pricing rules, typically known as swing pricing or dual pricing, “aim to adjust funds’ net asset values so as to pass on the costs stemming from transactions to the shareholders associated with that activity.”
To determine the degree of effectivity of the alternative pricing rules — specifically, whether they help funds retain capital during periods of market stress — the researchers used data from the FCA covering bond open-end funds domiciled in various EU jurisdictions. “The data cover a sample period from January 2006 to December 2016, spanning a number of high-stress episodes such as the 2008 global financial crisis, the European debt crisis, the downgrade of the U.S. government credit rating, and the Taper Tantrum,” they said.
Examining different alternative pricing models — full swing pricing, partial swing pricing, and dual pricing or bid-ask pricing — they determined that fund companies that subscribe to such alternative models implement adjustments to a fund’s NAV in times of low liquidity. This is consistent, they said, with the hypothesis that pricing rules matter to fund flows.
They also examined whether alternative pricing rules actually have an impact on fund flow levels during stress periods, a point on which market practitioners and regulatory bodies are divided. “[W]e find that open-end funds with traditional pricing rules experience significant outflows during market stress,” the authors said. “This effect, however, is almost completely reversed for funds that use alternative pricing rules, lending support to the view that such rules can reduce run risks.”
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