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SEC Proposals to Lower Liquidity Risk in Mutual Funds

Periods of large investor withdrawals may spell doom for both fund houses and investors. Many funds have piled up hard-to-sell assets, which are non effective during such periods of withdrawals. The five-member Securities and Exchange Commission ("SEC") unanimously voted last week to recommend new rules to help the multitrillion asset-management industry with effective liquidity risk management.

These additional safety measures will require mutual funds and ETFs to implement new plans to manage liquidity risks. The proposal calls for funds to keep a minimum amount of cash or cash equivalents that can be easily sold within three days (down from seven days currently required for mutual funds). Moreover, fund families may charge investors who redeem their holdings on days of increased withdrawals.

The move comes as part of five initiatives framed by the SEC to minimize risks imbedded in such funds and adequately shield them from any financial shock. Since the financial crisis, the asset management sector has been under increasing regulatory scrutiny. The proposals came after the Fed and IMF warned that certain funds may be incapable of keeping up with investor redemptions if there is a market rout.

Addressing the Redemption Challenges

The challenge is to meet shareholder redemptions during periods of stress and ensure smooth functioning of the funds amid large withdrawals. The SEC targets lower overall systematic risks in the $60 trillion asset-management industry and protection of investors' interests.

"Promoting stronger liquidity risk management is essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds," said SEC Chair Mary Jo White. "These significant reforms would require funds to better manage their liquidity risks, give them new tools to meet that requirement, and enhance the Commission's oversight."

The Reforms

Under the proposal, mutual funds and ETFs must implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. These would lead to timely redemption of shares and collection of assets by investors without hampering day-to-day running of the funds.

Further, the open-end funds will have to allow the use of "swing pricing" in certain cases. Swing pricing is a liquidity management tool designed to reduce the dilution impact of subscriptions and redemptions on non-trading fund investors. This step would enable mutual funds to reveal the fund's net asset value (NAV) costs related to shareholders' trading activity.

In addition, the proposed reforms would put a 15% cap on investments that can be made in hard-to-trade assets. As reported by The Wall Street Journal , some of the largest U.S. bond mutual funds have 15% or more of their money invested in such illiquid securities.

Need for Covering Liquidity Risks

Assets are deemed liquid when an investor can buy or sell large quantities rapidly at an expected price. During market rout, investors may engage in intense panic selling, for which funds must have adequate the liquidity or return cash to investors.

For instance, there are fears of bond liquidity once the Fed decides to hike rates. There is a growing concern that a massive exit from bonds may freeze the markets as the number of sellers may not match the number of buyers.

An ideal market would have the right level of liquidity at the right price. Redemption of bonds will increase the sell-off and then fund managers will have to sell the less liquid assets to match investors' cash demands. However, if a mutual fund or an ETF holds illiquid bonds, the price swings will be rapid and would create a vicious cycle as price drops will again end up in selling pressure.

Funds with High Liquidity & Low Redemption Fees

In such scenario, investors may buy funds that offer high liquidity and low redemption costs. As for liquidity, substantial stock holdings would provide the edge during a debt market sell-off.

While withdrawing money from mutual funds, there are certain charges or penalties that investors may have to bear. The charges may include sales load and 12-b1 fees. While selling a fund, investors may have to incur Deferred Sales Charge (Load).

There may be funds that carry no sales load, but have 12-b1 fees, which are operational expenses between 0.25% and 1% of the fund's net asset. Funds may also charge redemption fees. It is different from sales load since it is not paid to a broker but directly to the fund. The SEC has set a 2% maximum ceiling on redemption fees.

3 Funds to Buy

Hence, funds carrying no sales load and low expense ratio stuffed with substantial stock holdings in its portfolio should be safe picks.

We have narrowed our search based on favorable Zacks Mutual Fund Ranks. The following funds carry either a Zacks Mutual Fund Rank #1 (Strong Buy) or Zacks Mutual Fund Rank #2 (Buy) as we expect the funds to outperform its peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance.

The minimum initial investment is within $5000. The funds have encouraging returns for each of the 1, 3 and 5-year periods.

Fidelity Small Cap Growth ( FCPGX ) seeks long-term capital appreciation. Under normal circumstances, FCPGX invests at least 65% of its total assets in the common and preferred stocks of companies located in at least three countries in Europe, Australia and the Pacific Rim. FCPGX offers dividends, if any, and capital gains, if any, at least annually.

Fidelity Small Cap Growth carries a Zacks Mutual Fund Rank #1. While the year-to-date and 1-year returns are 9% and 18%, respectively, the respective 3- and 5-year annualized return is 16.6% and 16.7%. Looking at asset allocation, over 97% is invested in stocks, while it holds 2.8% as cash. Annual expense ratio of 0.90% is lower than the category average of 1.34%.

VALIC Company I Health Sciences ( VCHSX ) invests the majority of its assets in common stocks of healthcare products, medicine or life sciences related companies. VCHSX focuses mainly on investing in large and mid-cap companies. A maximum of 35% of VCHSX's assets is invested foreign companies.

VALIC Company I Health Sciences carries a Zacks Mutual Fund Rank #2. While the year-to-date and 1-year returns are 13.5% and 26.4%, respectively, the 3- and 5-year annualized returns are 29.9% and 29.7% respectively. Looking at asset allocation, nearly 94% is invested in stocks, while it holds 5.1% as cash. Annual expense ratio of 1.09% is lower than the category average of 1.35%.

Bridgeway Small-Cap Growth ( BRSGX ) aims to provide total return on capital over the long term. BRSGX invests in a broad range of small cap growth stocks that must be listed on the New York Stock Exchange, NYSE MKT and NASDAQ.

Bridgeway Small-Cap Growth carries a Zacks Mutual Fund Rank #1. While the year-to-date and 1-year returns are respectively 6.8% and 12.7%, the 3- and 5-year annualized returns are a respective 16.9% and 16.4%. Looking at asset allocation, 99.5% is invested in stocks. Annual expense ratio of 0.94% is lower than the category average of 1.34%.

About Zacks Mutual Fund Rank

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Pick the best mutual funds with the Zacks Rank.

About Zacks Mutual Fund Rank

By applying the Zacks Rank to mutual funds, investors can find funds that not only outpaced the market in the past but are also expected to outperform going forward. Pick the best mutual funds with the Zacks Rank.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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