Investors may not like the sound of their prices swinging, but “swing pricing” tools try to ensure price stability for longer term investors. Maybe “swing pricing” should be called “anti-swing pricing”.

Swing pricing is one type of “anti-dilution” provision, meaning it protects investors from the risk that the value of their investments could be diluted or inadvertently watered down.

Cost control and value preservation

Each time a portfolio manager buys or sells a stock or bond, they generate expenses, such as brokerage fees, administrative charges and taxes. “These costs can negatively impact the fund’s performance,” Goldman Sachs Asset Management, since running costs are collectively born by all the fund’s investors.

A sudden surge of investors subscribing (buying) or redeeming (selling) fund units can artificially and temporarily inflate these overhead expenses.

“Swing pricing is a mechanism that transfers an estimate of the trading costs generated to investors who are subscribing into and redeeming out of a fund,” said GSAM.

In addition to overhead expenses, large movements in to and out of a fund can influence the value of its assets, which can negatively impact longer term investors and potentially destabilise a fund.

For example, “big outflows can force a fund to sell holdings of less liquid securities that may require a price concession to attract a buyer,” Brookings Institution . “Shareholders in a fund who get out early can redeem at a better price than those who remain, because their redemptions are met before the fire sale forces the fund to mark down the value of its portfolio. This creates a ‘first-mover advantage,’ which can induce a rush to the door that amplifies the price movements that would otherwise occur.”

Swing threshold and swing factor

In a swing pricing system, a fund manager will recalculate the net asset value (NAV), the total value of a fund’s assets minus its liabilities, for incoming or exiting investors if a certain level of fund unit transactions is detected on the same day.

“The swing threshold is the amount of net subscriptions or redemptions that trigger the adjustment to the NAV,” the Brookings Institution.

Fund firms typically do not disclose the exact limits they set. For instance, Franklin Templeton it “will not disclose the swing thresholds as this may encourage some clients to deal below the threshold level undermining the ability of the mechanism to mitigate dilution.”

“When swing pricing is triggered, the NAV per share is ‘swung’ up or down by a amount to create a notional bid or offer price, ensuring that trading costs are borne by the subscribing or redeeming investor rather than existing shareholders in the fund,” according to Franklin Templeton. The amount varies for each fund and in each market, based on the level of expenses involved.

“The adjustment is known as the swing factor,” and is “generally no more than 2% or 3%,” according to the Brookings Institution.

Limitations

“While swing pricing has generally been an effective tool, it may not cover all liquidity scenarios adequately,” Mutualfunds.com. “Swing pricing only applies a percentage factor to larger flows. In the event of a significant liquidity crunch, the swing factor may not necessarily cover all transaction-related costs. In this situation, long-term shareholders may still be impacted by these trading fees.”

Question of fairness

“Swing pricing is a widely accepted anti-dilution standard used on Luxembourg domiciled funds,” Franklin Templeton stated.

“Studies have shown that swing pricing protects shareholders in the long term from suffering the costs of investment/disinvestment as a result of investor activity,” the Association of the Luxembourg Fund industry . “Swing pricing helps preserve investment returns enabling funds that apply swing pricing to show superior performance over time compared to funds (with identical investment strategies and trading patterns) that do not employ anti-dilution measures. In addition, swing pricing could act as a deterrent to short-term speculative investors as their investment will potentially need to have increased by more than twice the value of the swing factor for any gain to be realised.”

As Franklin Templeton put it: “Swing pricing is not a charge levied on the fund or investors. It is a tool that ensures that existing investors in the fund do not bear the trading costs associated with the portfolio manager having to trade due to the material activity of other shareholders into and out of the fund. Essentially, it is apportioning costs of trading to the shareholders that cause them.”