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Fitch Sees Liquidity Issues in Recent Proposal

Credit rating agency Fitch Ratings recently suggested that the SEC’s liquidity management proposal “could leave the funds better equipped to handle bouts of market volatility, but there may be unintended consequences.” Fitch argued that “fixed-income mutual funds and ETFs are facing a structural shift in market liquidity.” It suggested that the proposal may exacerbate that shift because funds may shy away from investment in already less-liquid investments, such as those in emerging markets, high yield bonds, and securities from small issuers. To support its view, Fitch cited its November 2014 analysis of the holdings of the five largest investment grade ETFs. According to Fitch, only 5 percent of the middle 50th percentile actually traded daily. Of the 25 largest holdings in the same ETFs, 54 percent traded daily.

Fitch also suggested that managers may shift to closed-end funds as a vehicle to invest in less liquid securities, and that those open-end funds that continue to invest in less liquid areas will face increased “cash drag.” However, Fitch argued that the swing pricing functionality proposed in which a fund could implement a policy to alter its NAV when redemptions or purchases exceeded a set threshold could reduce these negative effects by “curb[ing] potential market dislocations in the first place.”