Silent Swing: Do Open-End Funds Tilt Holdings Valuations in Response to Flows?

Abstract

Mutual funds face risks of dilution from trading costs when investors place purchase or redemption orders. To deal with this risk, the SEC in 2018 started allowing U.S. mutual funds to change their net asset value (NAV) up or down by a prescribed amount in response to abnormally large flows-a practice known as swing pricing. However, no U.S. fund has thus far chosen to adopt this practice. This paper provides evidence that funds can employ an alternative way to change the value of their portfolios in response to flows, namely by changing the valuation of their underlying holdings. We refer to this phenomenon as "silent swing pricing," as these swings in valuations are not announced and lack transparency, but still effectively achieve the same goal. Focusing on active fixed-income funds from mid-2008 to 2022, we find that a fund's valuation gap of a particular bond relative to peer funds' valuations is positively related to that fund's same-day flows. The sensitivity of valuations to flows is greater when a fund experiences outflows than when it has inflows, and when it holds more illiquid securities. The extent of silent swing pricing is attenuated, however, by return smoothing incentives when funds have poor past performance and fragile investor base. We show this practice has persisted even after the 2018 SEC rule change.

Keywords: swing pricing, flow fragility, open-end mutual funds, valuation, bonds

JEL Classification: G12, G18, G23