Markets

Complexity in Finance: Swing Pricing

Comments Off on Complexity in Finance: Swing Pricing

Swing Pricing is a feature which allows some investment funds to adjust their value under specific conditions. The goal is to have investor pay a fairer price, and bear the appropriate charges that their own investment in the fund generates. However, this features comes at a high price: increased complexity.

luxembourg

Luxembourg, host of many funds using swing pricing

What is swing pricing exactly?

Swing pricing is an adjustment, sometimes called 'dilution adjustment' in the price of a fund, that is in the price that you would pay if you want to subscribe to it, or the price that you would received if you were already an investor but wanted out. The underlying idea is that large transactions generate large transaction costs, and that it would be unfair that all the investors of the fund bear those costs if they are only caused by a single or a few other investors.

Not all transaction costs are targeted: funds buy and sell securities all the time, but the focus is here on increases or decreases in the size of the portfolio, not on internal turnover. The idea behind swing pricing is that internal turnover transaction costs are covered by the regular fees of the fund, but that transaction costs caused by subscriptions in the fund or redemptions are not, and the investors should not collectively bear those costs.

Therefore, funds using swing pricing increase slightly their price when a large subscription is made: the newcomer will thus pay a slight premium to account for the transaction costs. Reciprocally, a large existing investor wanting his investment back will receive slightly less than the true price of the fund, as shown in the image below.

swing-pricing-example

On the left side of the graph, we see the effect of the swing in case of a large redemption: the price is lowered, and thus the investor will receive less than the intrinsic value of the fund that he was holding. On the right side, we see that the price increases in the case of a large subscription to the fund: the new investor will pay a higher price than the intrinsic value of what he purchases.

The Challenges of Swing Pricing

As described above, the feature sounds fair, but its implementation seems difficult. It is. First of all, we need to decide of a threshold above which is subscription or a redemption is deemed "large". Then, we need to choose the amount of the premium. Both are challenging, and the practice differs very much depending on the Asset manager. Some are more transparent than others, but most keep a significant part of discretion as to when and by how much to change the price of the fund.

The table below shows the disparity of practice among several large asset managers in Luxembourg:

Asset Manager Swing Pricing Threshold Swing Pricing Factor
Aberdeen 5% of TNA ND
Credit Suise ND 2% max
NN IP 1-2% of TNA 0-1%
JPMorgan ND ND
State Street ND 2-3% max
Eastspring Investments ND 2% max
Robeco ND ND
Capital Group ND 2% max
Franklin Templeton ND 2% max
SEB ND 0.99% max

ND: not disclosed

It appears very clearly that most asset manager keep a veil of opacity on their swing pricing policy. Almost without exceptions, they also reserve themselves a wide discretion as to when to trigger the swing pricing: the fund is continuously shrinking? the manager thinks that it is in the best interest of existing investors to swing the fund? Those reasons are solid enough to trigger the swing, even if the agreed upon threshold has not been crossed.

Doing Swing Pricing Right

To do swing pricing "right", we need two things: transparency and rule-based parameters. Transparency is the simplest of both: investors need to know what they buy and where the price comes from. They need to know how the fund works and how much they will get when they will go out of the fund. Thus, the parameters of the swing pricing need to be public, and the underlying principles and calculations should also be disclosed to existing and prospective investors.

The parameters of the swing pricing, ie. the thresholds and the swing factors need to derive from rules, and not from arbitrary decisions of the asset manager. Their purpose is to protect existing investors, and rules can ensure that such remain the case at all time: for example, the asset manager shouldn't be able to discretionary decide to swing a fund to penalize an exiting investor. The threat of this happening should not even be out there. How to choose these parameters accurately using rules?

We need a careful analysis of the universe of securities in which the fund invests as per its policy. For example, equities and bonds markets are very different. US and emerging markets are also fundamentally different. We need to account for that. The more liquid the market, the lower the swing factor should be. The lower the lot premium (or the cost of trading large volume), the lower the swing factor should be. Those are only a few indicators from a large range available. Asset managers should rely more heavily and systematically on them. Some already do, but all should.

In the end, swing pricing must be approached with caution, and implemented in a way that is indeed to the advantage of existing shareholders of the funds. The only valid alternatives should be either to accept this significant layer of complexity and getting to the bottom of it, or to reject it plainly, and not using swing pricing at all. There should be no middle ground.

Who buys negative interest rate bonds?

Comments Off on Who buys negative interest rate bonds?
bank of Japan

Bank of Japan

For quite some time now, several governments started issuing bonds with negative interest rates. Our gut dislikes negative interest rates. First, how could a negative interest rate even exist? And Why would anybody be fool enough to pay an interest rate in order to lend money, i.e. to take a risk without apparent reward? Truth is, many investors purchase this securities, but the underlying reasons differ.

Continue Reading