A Look at Hidden Fund Valuation Adjustments

When investors buy or sell shares in mutual funds, the funds must trade their underlying holdings. This trading can incur significant costs that dilute the fund’s value for its long-term shareholders. The risk of dilution can also create a first-mover advantage where investors can benefit from selling a fund before others do, potentially triggering run-like behavior.

To address this, the SEC in 2018 adopted a rule that permitted funds the option to adopt "swing pricing." This mechanism would allow funds to adjust their Net Asset Value (NAV) upward or downward (by a specific percent called the "swing factor") in response to net in- or outflows that exceed a pre-set threshold. By effectively allocating the fund's trading costs more directly to the investors who buy or sell the fund (on the days with particularly large flows), swing pricing aims to protect the remaining shareholders. However, despite this tool now being available, this prescribed option to implement swing pricing has seen no uptake among U.S. funds. This reluctance may stem from a perceived inflexibility of the regulatory framework and challenges in obtaining precise, real-time flow information that is necessary for its implementation.

In a new paper, "Silent Swing: Do Open-End Funds Tilt Holdings Valuations in Response to Flows?", we provide evidence that bond mutual funds engage in an alternative practice, which we term "silent swing pricing." An underlying premise behind this idea is that funds have considerable discretion in adjusting valuations of their holdings, particularly for illiquid securities like corporate bonds. We hypothesize that funds may utilize this discretion to systematically tilt bond valuations – downwards during outflows and upwards during inflows. If funds engage in such a practice, this could achieve end outcomes similar to formal swing pricing, albeit through a different mechanism that is less transparent.

To examine this hypothesis, we analyze month-end holdings, valuations, and daily flows for U.S. active bond mutual funds from 2008 to 2022. This sample encompasses 33,774 unique corporate bonds held by 753 U.S. active domestic bond funds. For each bond that a fund holds, we measure 'price deviation' as the difference in how the fund values the bond compared to the valuations by peer funds. Using regression analysis, we then test the relationship between this price deviation and the fund's net flow on the same day, controlling for lagged flows, returns, and extensive bond-by-time and style-by-time fixed effects. A positive relationship in this regression would indicate that funds tilt bond valuations in the same direction as their daily flow, consistent with silent swing pricing.

Our analysis finds significant evidence that bond funds engage in this type of silent swing pricing. On average, a 1% net flow is associated with a valuation tilt of approximately 4 basis points in the same direction as the flow, with a larger effect (around 6 basis points) observed for high-yield bonds. Suppose two funds (A and B) hold the same bonds: if fund A experiences outflows and fund B inflows, fund A tends to mark bond valuations lower relative to fund B.

This valuation tilt is stronger for bonds where funds have more discretion and for bonds with higher trading costs. Specifically, the sensitivity of valuations to flows increases with measures of bond illiquidity (like the Amihud measure) and for bonds that lack recent traded prices in TRACE. This suggests funds strategically employ silent swing where the ‘need’ (higher trading costs) and ‘opportunity’ (less price transparency) are the greatest. The practice is weaker among younger funds or those with poor recent performance. Further, we find that silent swing pricing practices have continued even after the 2018 rule that permitted funds to formally adopt swing pricing.

A particularly notable feature of silent swing pricing that we identify is a clear asymmetry, as this practice of tilting valuations in the same directions as flows is overwhelmingly concentrated in times of outflows. In other words, funds mark down valuations when investors are selling the fund but do not mark up when they experience inflows. This asymmetry aligns with the greater risks associated with outflows from a fund, as outflows have the potential to cause run-like scenarios. It nevertheless contrasts with the SEC's swing pricing rule, which prescribes symmetrical adjustments to inflows and outflows alike.

As a placebo-type test, we compare these effects among bond mutual funds to the same behavior among bond ETFs. We find that ETFs do not display similar evidence of silent swing pricing, consistent with their lower vulnerability to flow-driven trading costs due to the structural differences between how ETFs and mutual funds handle redemptions.

Why might funds prefer this silent swing approach over formal swing pricing? While our empirical findings cannot easily determine underlying motives, silent swing offers potential advantages. For example, it does not require precise, real-time net flow data – a commonly cited limitation of the formal rules. Instead, funds merely need to know the direction of daily flows along with a rougher sense of the magnitude. Furthermore, it allows for more flexible asymmetric responses to outflows versus inflows, which funds also appear to take advantage of.

Our findings provide important insights for academic research and policy debates surrounding mutual fund stability. The analysis suggests bond funds are already practicing a form of swing pricing implicitly through valuation adjustments rather than through explicit pre-determined NAV changes when they are faced with abnormally large flows. However, the opaque nature of silent swing pricing raises transparency concerns, as investors may not be fully aware that such valuation adjustments are occurring.

This discretion in adjusting valuations also touches upon broader governance issues within asset management. Silent swing pricing raises important questions about fiduciary responsibility, transparency, and fairness. Investors are generally unaware when valuations are internally adjusted, potentially impacting share values without clear disclosure.

Silent swing pricing reflects the challenges of managing flows and associated trading costs, but also highlights the need for transparency to maintain investor trust. As the swing pricing debate continues, our research provides an important look under the hood at how some funds are currently managing these inherent risks.

_______________

By Jaewon Choi (Seoul National University - Department of Economics), Mathias Kronlund (University of Illinois at Urbana-Champaign and ECGI), and Ji Yeol Jimmy Oh (Sungkyunkwan University)

The ECGI does not, consistent with its constitutional purpose, have a view or opinion. If you wish to respond to this article, you can submit a blog article or 'letter to the editor' by clicking here.