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The SEC’s Liquidity Proposal in Detail: DERA Study

In explaining the need for its recent released liquidity proposal, the SEC relied heavily on analysis from a paper issued by the Division of Economic and Risk Analysis entitled Liquidity and Flows of U.S. Mutual Funds. Chair Mary Jo White noted that the economic analysis reflected in the study was “essential in formulating these reforms.”

The study surveyed changes in the mutual fund industry, noting that assets in mutual funds grew from $4.4 trillion in 2000 to $12.7 trillion in 2014. In addition to the significant growth in assets, the study found a significant shift in assets away from funds that primarily invest in U.S. equities. U.S. equity funds represented 65.2 percent of industry assets in 2000, but fell to 44.5 percent in 2014. Over the same period, investments in foreign bond and foreign equity funds rose from 11 percent to 17.4 percent. Alternative strategy funds accounted for $365 million in assets in 2005, but grew to $334 billion by 2014. The mean alternative strategy fund experienced an inflow of 2.4 percent of assets each month over that period, making the category the fastest growing among mutual funds (yet still only accounting for 2.6 percent of total assets).

The study also examined how funds respond to outflows and found that, for municipal bond funds, a 1 percent outflow results in a 0.05 percent increase in the of the portfolio held in bonds and a corresponding decrease in the percent of the portfolio held in cash, thus resulting in decreased fund liquidity. For U.S. equity funds, the study found that “[a] 10% outflow increases the impact of selling $10 million of the asset-weighted average equity portfolio holding by 11 basis points.” However, when examining “how initial [quarter] equity portfolio liquidity affects the relation between net fund flows and equity portfolio liquidity,” the study found that “outflows only impact equity portfolio liquidity for the funds with low initial equity portfolio liquidity.” The study also found a more pronounced effect resulting from outflows in funds with fewer assets. The SEC’s press release on the liquidity proposal concludes that “the average U.S. equity fund appears to sell relatively more liquid assets to meet large redemptions, rather than selling a strip of the fund’s portfolio.”

However, the study found that funds increase their liquidity in the face of greater flow volatility such that “a one standard deviation increase in flow volatility increases the percentage of the fund portfolio held in cash by 0.07%.” Looking only at U.S. equity funds, “[a] one standard deviation increase in flow volatility decreases the impact of selling $10 million of the asset-weighted average equity portfolio holding by 4.6 basis points.” The study also found that municipal bond funds tend to increase liquidity with increased flow volatility: “[a] one standard deviation increase in flow volatility decreases the percentage of a fund’s portfolio held in municipal bonds by 0.09% and increases the percentage of a fund’s portfolio held in cash by 0.08%.”

The study found that the mean standard deviation of monthly net flows for alternative strategy funds was 13.6 percent, 9.4 percent for emerging market debt funds, 5.8 for U.S. equity funds, and 2.7 percent U.S. municipal bond funds at 2.7 percent. The liquidity release suggested that these numbers mean that fund categories with a higher standard deviation in fund flows should have a higher corresponding three-day liquid asset minimum.

The paper also looked at holdings of cash in mutual funds and found that the percentages varied significantly. On average, funds held 1.8 percent of assets in cash; however, a fourth of funds held 0.2 percent or less and a fourth held 4.4 percent or more in cash. Within fund categories, the percentage of holdings in cash varied even more: 10 percent of each mixed strategy funds and U.S. government bond funds had a net negative cash position while 10 percent of the funds in each category had more than 13 percent of their assets in cash.

The study found evidence that funds adjust to changing market conditions. For each 1 percent decrease in market liquidity, fund liquidity decreased 0.93 percent, and for every 1 percent increase in market liquidity, fund liquidity increased 0.82 percent. The liquidity release noted that “while the results are consistent with the view that U.S. equity funds actively manage their portfolio liquidity, funds appear to make only minor adjustment to their portfolio in response to changes in market liquidity.”