What Is Swing Pricing and How Does It Prevent Dilution?

Mutual funds allow investors to pool money to purchase diverse securities. Each mutual fund determines its share price based on its Net Asset Value (NAV). The NAV represents the fund’s per-share market value, calculated by taking the total value of all assets, subtracting liabilities, and dividing by outstanding shares. This calculation occurs at least once every business day, typically after the close of normal trading on the New York Stock Exchange. Investors buy and sell shares at this calculated NAV, which is important for determining the value of their holdings.

Understanding Fund Dilution

Fund dilution occurs when the trading costs associated with significant investor inflows or outflows are effectively borne by all existing shareholders, rather than primarily by those transacting. When investors buy or sell shares in a mutual fund, the fund manager often needs to trade underlying securities to accommodate these transactions. These trades incur various costs, such as brokerage fees, taxes, and the difference between buying and selling prices, known as the bid-ask spread.

These transaction costs, if not properly managed, can reduce the fund’s overall value, negatively impacting the returns of long-term investors who did not initiate the trades. Imagine a collective pool of money where new participants add or remove funds; the act of adding or removing can stir the pool, creating ripples that affect everyone. When a fund experiences large net inflows, the manager must purchase more assets, incurring costs. Conversely, large net outflows necessitate selling assets, also generating costs.

The problem of dilution arises because, without a mechanism to allocate these costs, they are spread across the entire fund’s assets, diminishing the value for all shareholders. Studies have estimated that U.S. stock mutual funds can average around 1.44% in transaction costs per year, which are generally not included in the reported expense ratio. These implicit costs, such as market impact from large trades or the bid-ask spread, can be substantial and affect all shareholders if not addressed.

What is Swing Pricing?

Swing pricing is a mechanism used by investment funds to adjust the Net Asset Value (NAV) per share. It aims to protect existing shareholders from the dilutive effects of trading costs incurred by large inflows or outflows of money. It operates by incorporating an estimate of these transaction costs directly into the fund’s daily share price, ensuring transacting investors bear a portion of the costs their transactions generate.

Unlike a simple bid-ask spread, which is a static difference between buying and selling prices, swing pricing dynamically adjusts the fund’s NAV itself. When there are substantial net inflows, the NAV is adjusted upwards, meaning new investors pay a slightly higher price. Conversely, during periods of significant net outflows, the NAV is adjusted downwards, resulting in redeeming investors receiving a slightly lower price. This adjustment is not a fee retained by the fund manager; rather, it is added back into the fund’s assets, benefiting the remaining shareholders.

The Securities and Exchange Commission (SEC) in the United States permits, but does not mandate, open-end mutual funds to use swing pricing as an anti-dilution tool. This option has been available since 2016, with an effective date of November 2018. The SEC’s allowance enables funds to adjust their NAV to pass on the costs associated with shareholder trading activity to the transacting parties, thereby safeguarding existing investors from dilution.

How Swing Pricing Works in Practice

The implementation of swing pricing involves adjusting a fund’s Net Asset Value (NAV) based on the net flow of investor money and predefined thresholds. Two main approaches exist: full swing pricing and partial swing pricing. Full swing pricing involves adjusting the fund’s NAV every day, regardless of the size of the net capital flows, with the direction of the swing determined by whether there are net inflows or net outflows.

Partial swing pricing, also known as semi-swing pricing, is more commonly adopted. It adjusts the NAV only when net investor flows—the difference between inflows and outflows—exceed a specific “swing threshold.” This threshold is typically expressed as a percentage of the fund’s net assets. For instance, a fund might set a swing threshold at 1% or 5% of its NAV. If daily net activity, such as net subscriptions or redemptions, surpasses this threshold, the fund’s NAV is then adjusted by a “swing factor.”

The swing factor represents an estimated percentage of transaction costs, including brokerage fees, taxes, and bid-ask spreads, that the fund expects to incur due to the net flows. For example, a swing factor might be set between 0.10% and 2% of the NAV. When net inflows exceed the threshold, the NAV is swung upwards by this factor, making new shares slightly more expensive. Conversely, for net outflows, the NAV is swung downwards, resulting in a slightly lower redemption price. The maximum swing factor permitted by the SEC for US mutual funds is 2% of the NAV per share.

Implications for Investors and Funds

Swing pricing plays a role in fostering fairness among mutual fund investors. It ensures that the costs associated with buying or selling fund shares, which necessitate underlying portfolio transactions, are primarily borne by the investors causing those costs. This prevents existing, long-term shareholders from subsidizing the trading activity of others, thereby protecting their investment value from dilution.

For investment funds, implementing swing pricing helps maintain the integrity of the Net Asset Value (NAV) and supports fund stability. By allocating transaction costs to transacting investors, funds can better preserve their capital and avoid erosion of value, particularly during periods of significant market volatility or large investor movements. This practice can contribute to more consistent long-term performance for the fund as a whole. While the exact details of swing pricing policies, including thresholds and factors, may not always be publicly disclosed to prevent exploitation, funds typically outline their general approach in their prospectus.