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 (those with less than $1 billion in under management) given until mid-2019 to comply. While these regulations will impose restrictions on what assets funds can hold and in what quantities, we believe funds that adapt appropriately 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 15% 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 that 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.
The general counsel for the Investment Adviser Association has contended the cost of compliance with the liquidity risk rules will be huge. We disagree. By incorporating the transaction cost requirements into portfolio construction, as opposed to checking after the fact, implementation expense will be low, and there will be improvements in portfolio performance. Mutual fund managers that already use such an integrated approach have realized a number of benefits, including:
- higher returns net of portfolio implementation costs;
- greater diversification, which in the case of the SEC regulations, involves diversification along the lines of liquidity characteristics;
- lower turnover, a major driver of reducing costs, hence enhancing realized liquidity;
- reduced rebalancing costs, in a world in which average annual turnover is nearly 100%;
- more stable portfolios and reduced 'overreaction' to noisy excess return signals; and
- greater ability to expand assets under management for a particular strategy, a core issue when considering whether to close a fund to further investment.
There are roughly a dozen papers, written by a diverse group of researchers, that support these conclusions in one way or another. We predict they will be brought back into the spotlight in view of the SEC's current perspective on proper fund management and disclosure.
In order to backtest some of these assertions, we recently examined a series of long-only, long-short and market-neutral portfolios, rebalanced monthly over a 136-month period ended June 2016. By including implementation costs into the portfolio strategy, net returns rise by 39%, while average annualized transaction costs fall 84%. Diversification increases roughly 10%, even as the cost of implementation plummets. These results are consistent with those of previous studies.
More liquid portfolios are the result, while realized returns are enhanced. This suggests not only that the SEC is on the right track with this rule, but that its actions could improve the investor experience beyond just enhanced disclosure requirements.
We sought to prove this contention through an examination of two mutual funds in the market today, one devoted to U.S. securities and the other to a global set of stocks. Using our own methodology, the existing portfolios are augmented with extremely liquid stocks from a universe of securities with liquidity characteristics in keeping with the SEC rule. Although preliminary, the results are suggestive of what can be expected.
Suppose, for example, that the required percentage of liquid securities is 10%. From November 2009 through July 2016, and without changing the funds' core investments, several good things happen. Average annualized net returns rise by 26% for the U.S. stock fund and 2.2% for the global investment portfolio. Very few new names needed to be added to the core holdings in order to achieve this result. The average annualized rebalancing cost, based on a monthly rebalance exercise, declines by 16% in the U.S. fund and 12% for the global one. Risk-adjusted net returns rise by 20% and 12.5%, respectively.
We offer a basic and very practical message: Cost reduction and enhanced portfolio liquidity are not only the domain of trading desks. The SEC ruling recognizes this and points the way toward portfolio performance and liquidity risk reduction. Lower frictional costs, leading to improvement in realized returns and better alignment of return with risk, starts with the inclusion of implementation costs in the stock selection and portfolio construction process.