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How a New SEC Liquidity Rule Could Lower Costs for Mutual Funds and Boost Returns for Investors

Domowitz_Ian
January 27, 2017 Ian Domowitz

The Securities and Exchange Commission has voted to adopt new rules affecting the management of liquidity risk in mutual fund portfolios. The rules are set to take effect in late 2018 for most mutual fund managers, with smaller managers (<$1B AUM) given until mid- 2019 to comply). While these regulations will impose restrictions on what assets funds can hold and in what quantities, we believe that funds which adapt appropriately to the will be rewarded with lower transaction costs and higher returns for their investors.

According to the rules, liquidity risk is essentially defined as the risk that a fund could not meet requests to redeem shares without material dilution of remaining investors’ interests. The mandated approach is granular. A fund is required to determine a minimum percentage of assets, which must be invested in highly liquid investments. A fund also is prohibited from buying additional illiquid securities, if more than fifteen percent of its net assets already are determined to be illiquid.

As the rule reads now, liquidity cannot be judged by legacy measures such as market capitalization. We agree. “Highly liquid investments” are those capable of conversion into cash within three business days without significantly changing the market value of the investment. Similarly, “illiquid investments” are those which cannot be sold in current market conditions in seven days without moving the market unduly. Identifying such groups and providing suitable strategies for implementation are standard fare for transaction cost analysis, or TCA.

Continue reading, ‘The Fifteen Percent Solution: How a New SEC Liquidity Rule Could Lower Costs for Mutual Funds and Boost Returns for Investors