SEBI has been bringing in various risk mitigation measures in debt funds since the IL&FS crisis unfolded in late 2018. In its recent consultation paper, the market regulator has proposed introducing the concept of swing pricing in open-end debt funds. Aimed at ensuring fair treatment to existing investors and those entering or exiting a fund, the framework looks to protect investors from any impact caused by significant inflows/outflows in a fund. Moreso, during liquidity-challenged environments.
What is the swing pricing mechanism?
Swing pricing refers to the process of altering a fund's net asset value (NAV) to efficiently pass on transaction costs of significant inflows or outflows to the investors associated with such activity. It's designed to protect long-term investors from value erosion of their fund holdings due to the action of others within the same fund. As of now, SEBI has proposed to mandate a swing pricing mechanism in high-risk debt funds during market dislocation, while it will be optional during normal market time. However, at a later stage, the regulator will examine the applicability of the mechanism to equity and hybrid funds.
Swing pricing is of two types - full and partial. In full swing pricing, a fund NAV is adjusted (swung) up or down every trading day, irrespective of the size of investor dealing. In partial swing pricing, a fund's NAV is adjusted when the net inflows/outflows breach a certain pre-determined swing threshold (usually set as a percentage of AUM). The NAV is adjusted by the swing factor if the net inflows/outflows are above the swing threshold.
So, if net inflows exceed the swing threshold, the NAV will be adjusted upwards for the swing factor, and in case of redemptions breaching the threshold, NAV will be adjusted downwards. This adjusted NAV then effectively becomes applicable for all entering and exiting investors.
To explain swing pricing with an example, assume a fund with NAV of Rs 200 and a swing factor of 1 per cent of the NAV with a swing threshold of 5 per cent of the fund's net inflow or outflow. If the fund witnesses a net inflow of 10 per cent of AUM, the NAV will be adjusted upward to Rs 202. Thus, the investor entering the fund will get to bear the associated cost. Now, suppose the fund sees a 10 per cent redemption. In that case, the NAV will get downward adjusted to Rs 198, preventing those redeeming earlier, anticipating a market dislocation, from benefiting at the cost of existing investors. However, if a net inflow or outflow of less than 10 per cent occurs, then the swing mechanism is not implemented, and the fund's NAV stays at Rs 200.
This kind of NAV adjustment helps significantly reduce redemptions during stress periods. Additionally, it reduces first-mover advantage as the costs that exiting investors impose on the fund are borne by them. Thus, this mechanism ensures more equitable treatment of entering, existing, and exiting investors.
In the consultation paper, SEBI has proposed a hybrid model - partial swing during normal times and a mandatory full swing during times of market dislocation. To insulate (to a certain extent) retail investors and senior citizens from the applicability of swing pricing, SEBI has exempted redemptions up to Rs 2 lakh for all unitholders and up to Rs 5 lakh for senior citizens from this mechanism.
Aimed at safeguarding the interest of investors during stressful times, it is certainly a welcome investor-friendly move. Having said that, a few open-end questions do remain like appropriate parameters for swing pricing, swing threshold, etc. Thus, SEBI may need to explore and answer these aspects before implementing the swing pricing mechanism.