- The Securities and Exchange Commission’s proposed liquidity classification for open-end investment funds may make reports easier to compare across funds, but may not accurately capture changes in the liquidity of equity funds.
- The proposed regulation's 10% stressed trade size may be too high for large equity funds, resulting in many funds exceeding the regulatory limit on illiquid assets.
- The proposed volume-based approach may not provide a complete picture of liquidity, especially in volatile markets, and may create challenges for fund managers to keep funds within the regulatory limits.
The Securities and Exchange Commission (SEC) recently proposed amendments to the liquidity classification of open-end investment funds, aimed at standardizing reporting practices.1 This could aid in the comparison of fund-liquidity reports by enhancing the information available to investors. But under the proposed approach, in its current form, many large equity funds would exceed regulatory limits, and changes in equity funds’ liquidity may not be accurately reflected.
What would change?
Under both the current and proposed rules, asset managers categorize portfolio holdings into liquidity buckets. This classification is based on how many days it takes to liquidate2 a proportion of each holding, while controlling the impact the trade has on the asset’s market value. Currently, managers may define both the proportion (called reasonably anticipated trade size) and the limit on value impact (called significant price impact) considering fund characteristics.3 The first potential key rule change is to impose a uniform 10% trade size on all funds. Second, it replaces the price-impact limit by a limit on the traded volume: Managers may assume that 20% of the average daily volume of any publicly listed equity can always be sold in one business day.
We analyzed the impact of these two regulatory changes on large equity funds separately. We found that both the prescribed trade-size assumption and the new, volume-based classification approach may have unintended side effects.
A uniform 10% stressed trade size — does one size fit all?
Our analysis shows that the proposed 10% trade size might be too high for large equity funds. We compared the proposed classification to MSCI’s RiskMetrics® LiquidityMetrics® implementation of the current rules, assuming security-specific price-impact limits from MSCI’s methodology.4 We found that all nine of the analyzed large equity funds exceeded the illiquid limit5 under the proposed trade size several times over the last three years, in terms of both the proposed and current classification approach.
Improving liquidity classifications in March 2020?
We further found that the new, volume-based approach would have shown improving liquidity during the COVID-19 outbreak of March 2020, as traded volumes increased in that period. Conversely, the current, price-impact approach would have captured the worsening market liquidity. This underscores that a classification methodology relying solely on traded volumes may not reflect the whole picture, especially in volatile markets.
Under the proposed rules, liquidity appeared to improve at the onset of the COVID crisis
Source: Virtu Financial, Refinitiv, Lipper, MSCI
Managing illiquid holdings
Finally, we found that the daily changes to the illiquid bucket can be extreme, even with a much smaller trade size. Consequently, a fund manager keeping illiquid holdings well below the regulatory limit might have seen the portfolio crossing it from one day to the next, as shown in the exhibit below. This would have been the expected outcome if market liquidity had deteriorated suddenly, but we saw that this was not always the case.
Liquidity would change suddenly, even when market liquidity does not
For the analysis, we assumed a 3% trade size. Source: Lipper, Refinitiv
We observed days when traded volumes spiked collectively for many stocks, typically around quarter-ends when earnings reports are published. These caused the sudden drops in the share of illiquid holdings across funds, even when markets remained calm. When the volume spikes phased out the averaging window, the illiquid fraction jumped again.
The rule change in practice
Reducing model risk and improving transparency for investors are undoubtedly important objectives that the proposal can address. The proposed regulation has a flip side, however: It may not accurately show changes in equity-fund liquidity. Fund managers may want to assess what impact this potential regulatory change would have on their portfolios.
1 “Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT.” Securities and Exchange Commission, Nov. 2, 2022.
2 Under the proposed rule, if conversion to USD takes less than three days, the holding is highly liquid. If it takes less than a week, the holding is moderately liquid. Otherwise, the holding is illiquid.
3 Characteristics should include redemption history, investor concentration, investor type and other factors. Many of our clients use RATS values that are much smaller than 10%, typically in the 3-5% range.
4 MSCI’s RiskMetrics® LiquidityMetrics® models liquidity along three dimensions: execution time horizon, trade size and price impact. For a fixed trade size and price-impact limit, it estimates the time horizon needed for selling. These liquidation horizon values are then the input of the SEC’s liquidity-classification rules. MSCI also calibrates price-impact limits in the spirit of the current rules. These limits were calibrated based on estimated transaction costs corresponding to expected trade sizes.
5 Both the new proposal and the currently effective regulation prescribe a 15% cap on illiquid holdings.