January 2017
The Fifteen Percent Solution: How a New
SEC Liquidity Rule Could Lower Costs for
Mutual Funds and Boost Returns for
Investors
AUTHORS
Ian Domowitz and Ameya Moghe, ITG Analytics
A VERSION OF THIS ARTICLE ORIGINALLY RAN ON PENSIONS & INVESTMENTS ON JANUARY 27, 2017.
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 (<$1B AUM) given until mid2019 to comply). While these regulations will impose restrictions on what assets funds can
hold and in what quantities, we believe that funds which adapt appropriately to the 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 fifteen percent 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 which 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, or TCA.
The general counsel for the Investment Adviser Association has contended that 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 who 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
§
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, which support
these conclusions in one way or another. We predict that 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 back-test 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 ending
June 2016. By including implementation costs into the portfolio strategy, net returns rise by
39%, while average annualized transaction costs fall by 84%. Diversification increases by
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 their 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 US 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%. Over the
period 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 US 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 US and 12% for global
investments. 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
towards 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.
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