“Swing pricing” and “redemption gates”: key tools for protecting long-term investment

22/02/2019

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A few years ago, French market authorities and institutions, led by the French Financial Markets Authority (AMF - "Autorité des Marchés Financiers") and the French Asset Management Association (AFG - "Association Française de Gestion"), authorized the application of anti-dilution methods, such as "swing pricing" and "redemption gates", to UCIs.

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[Jean-Marie Catala, Deputy CEO]
How would you define this type of mechanism that can now be applied by asset management companies?

Jean-Marie Catala : Anti-dilution mechanisms are designed to protect the existing investors in a UCI against the risk of dilution by adjusting the net asset value of the fund. The aim of swing pricing is to reduce the cost to existing investors of a restructuring of portfolio ownership due to liability-side movements (subscriptions and redemptions of investors). The mechanism work by increasing the net asset value (NAV) if the liability-side variation is positive and decreasing NAV if the variation is negative. The protection mechanism is triggered in accordance with a logic of preserving fairness between investors.

 

Can you explain more precisely how liability movements cause a risk of dilution?

Jean-Marie Catala : Dilution corresponds to the impact that a subscription − due to a new investor entering a fund − or a redemption can have on the value of the fund. Obviously, the price at which a financial security is bought is different from the price at which it sells, and this price difference results in a “bid-ask spread” – in other words, the range of prices acceptable to the buyer and seller. As a general rule, funds are valued at a price in the middle of this range.

“Fixed-income assets priced in the middle of the range are sensitive to dilution risk in the event of significant fund flows”

Consequently, when investing the subscribed sums in the UCI, the fund manager may have to pay a higher price for each security than its value obtained by calculating the fund’s NAV. The opposite phenomenon occurs when redeeming shares in the fund. In this case, the difference between the price negotiated on the market and the price calculated from the NAV will be borne by all the investors in the fund and will have a negative impact on fund performance.

 

Which underlying assets are most exposed to the risk of dilution?

Jean-Marie Catala : When underlying assets are considered to be liquid, their bid-ask spread is generally low. By contrast, in the case of less liquid assets, this spread widens and can undergo significant movements. All mid-price fixed-income assets – such as high-yield credit, emerging market bonds and convertible bonds – are sensitive to dilution risk if a fund experiences major inflow or outflow.

 

In the event of liquidity stress, it is now possible to have recourse to another mechanism that places a ceiling on redemptions. How does that work?    

Jean-Marie Catala : Yes, you are right that the mechanism of placing a restrictive ceiling on redemptions, also called a “gate provision” or “redemption gate”, is permitted under the French Monetary and Financial Code (“Code Monétaire et Financier”). This mechanism is used to distribute redemptions over several NAVs by placing a temporary limit on them, So, the “redemption gate” differs from a total suspension of redemptions, which, until now, was the only solution available to respond to exceptional situations.

The main aim of this mechanism is to protect the quality of the fund’s assets by preserving them from forced sales under extremely degraded conditions. It also enables the fund to honour redemptions progressively, while also preserving equality between investors. So, this mechanism consists in reducing the liquidity risk caused by an excessive imbalance between the liquidity of the fund’s assets and the redemption conditions offered to investors.

To be eligible to apply this legislation, the asset management company must demonstrate the existence of exceptional circumstances and must also show that this staggering of redemptions over time is dictated by the interests of the investors or of the general public. Therefore, this mechanism will only be activated in the event of an exceptional degradation of market liquidity, resulting in an inability to honour all the redemption requests.

 

So, it provides welcome protection for investors… 

Jean-Marie Catala :

Absolutely. This redemption gate system allows fund managers to control the illiquidity risk by reducing the impact that a lack of liquidity can have at a given time “t”, in the event of extreme market stress, to the exclusive benefit of the investors. The relative liquidity of different asset classes can vary over time, impacting both the cost and time of liquidation of the underlying assets in a portfolio. The illiquidity risk, under certain exceptional circumstances, is manifested in the difficulty of finding market counterparts or reasonable prices.

This risk is obviously more pronounced for asset classes of restricted market depth, such as certain mid-cap or corporate bond segments. In the event of “forced” sale, the value of these assets can drop significantly, and the bid-ask spread can widen dramatically. This ultimately results in financial losses for the portfolio.

 

In practice, how do you deploy these two protection systems at Groupama Asset Management?

Jean-Marie Catala :

We should remember that the mechanism of swing pricing is preventive, to the extent that it is applied regularly, whereas the mechanism of redemption gates is curative and is only activated in the event of exceptional circumstances under the responsibility of the asset management company.  With regard to redemption gates, we will apply this mechanism in accordance with the recommendations of the AMF: so, a combination of two conditions are necessary to trigger this mechanism. First, requests for redemption must exceed a threshold, which is set at 5% of the fund’s NAV, and, secondly, triggering of the mechanism must be impelled by exceptional and extremely degraded market conditions.

“Asset management companies mainly deploy these mechanisms for new funds, and less for the existing UCIs.

Once the mechanism is triggered, our decision will be explained to the AMF and made public. In conformity with the instructions of the Authority, the maximum duration of the gate provision is 20 NAVs over a three-month period. For multi-asset funds, the trigger threshold must be the same for all the asset classes.  The gate provision is a virtuous mechanism, because, in the past, without the ability to activate redemption gates, the deterioration of the portfolio’s liquidity and value would penalize the investors who had not yet left, leaving them holding totally illiquid assets.

 

And what about swing pricing?

Jean-Marie Catala : We have opted for a “partial swing pricing” method: with partial swing, the NAV of a fund will only be adjusted if the net inflow or outflow exceeds a predetermined threshold.  So, here too, we implement a trigger level. The aim is to ensure that swing pricing is only triggered when the dilution effect is too severe to be borne by the existing investors in the UCI. Once triggered, the NAV will be adjusted by a “swing factor” to offset the dilution effect. We have set up an independent in-house committee responsible for the governance of this mechanism. This committee issues quarterly validations certifying the consistency of the various thresholds and the amplitude of the NAV swing, and it ensures that the application of swing pricing is uniform and consistent.

 

Are these mechanisms now common in the asset management industry?

Jean-Marie Catala : They will be applied to the funds with underlying assets that are most sensitive to the risks of dilution and illiquidity. In practice, this means our fixed-income funds under French and Luxembourgish law – convertibles, “unconstrained” and credit – and the equity funds invested in small and mid-caps. The statutes and prospectuses of these funds are currently being adapted to integrate these modifications. The mechanisms will be deployed after receiving the approval of the AMF and after formally informing the investors. We are convinced that the deployment of these mechanisms will provide better protection to stable, long-term investors and that this protection will play a major role in the long-term savings market, especially in the context of new pensions products.

 

Will these mechanisms be applicable to your entire fund range?

Jean-Marie Catala : They will be applied to the funds with underlying assets that are most sensitive to the risks of dilution and illiquidity. In practice, this means our fixed-income funds under French and Luxembourgish law – convertibles, “unconstrained” and credit – and the equity funds invested in small and mid-caps. The statutes and prospectuses of these funds are currently being adapted to integrate these modifications. The mechanisms will be deployed after receiving the approval of the AMF and after formally informing the investors. We are convinced that the deployment of these mechanisms will provide better protection to stable, long-term investors and that this protection will play a major role in the long-term savings market, especially in the context of new pensions products.

 

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