The SEC Is Proposing Big Changes To Funds. Who Benefits?

The Securities and Exchange Commission recently issued two proposals that could change the way open- and closed-end funds operate, and those changes could have a significant impact on investors.

In this article, I’ll walk through each proposal and then assess how the proposed rule changes could affect investors.

What the SEC Proposes

Performance-Based Fees

The first proposal would loosen the rules governing investment advisors’ ability to levy performance-based fees. There are two aspects to this proposal—advisors of registered investment funds and those who manage individuals’ assets in vehicles like separately managed accounts.

With respect to fund managers, the proposal would allow them to charge as much as 20% on any net realized and unrealized gains over a specified period. Imagine a fund that has $1 million in net assets today, gains 10% over the next 12 months, and then levies a 20% fee on the $100,000 gain it made. In that scenario, the manager would levy a $20,000 performance fee (20% of the $100,000 gain), leaving investors with $1,080,000.

That would mark a big departure from the “fulcrum fee” approach that’s permitted today. Under this approach, a manager can levy a performance-based adjustment, but it must be symmetrical—if the fund outperforms a specified benchmark by a certain amount, it earns an extra fee, but if it lags to the same degree, it incurs an equivalent penalty fee.

The proposed approach would essentially disregard relative performance. If, say, a fund earned 6% in realized and unrealized gains and the index rose 10%, that fund’s manager would still stand to pocket a performance-based fee, despite lagging. The reverse holds, too; if the fund gained 6% but the bogy fell 10%, it could only levy the fee adjustment on the 6% gain, not the 16-percentage-point outperformance margin.

The proposal would also lower the bar to be eligible for performance-based fees outside retail funds (such as separately managed accounts). Until now, advisors could levy such fees on the accounts of “qualified clients.” The proposal would relax the standard so advisors could charge performance fees on accountholders meeting the lesser “accredited investor” requirement as well.

Interval Fund Repurchases

The second proposal pertains to rules that govern when and how interval funds cash out investors. If you’re unfamiliar, interval funds are a type of closed-end fund that investors can purchase at any time but can only sell at predetermined intervals, subject to a manager-imposed cap. Normally, an interval fund would offer to repurchase 5% of outstanding shares at net asset value each quarter.

Interval funds gained popularity in recent years as managers sought ways to deliver private market access to a broader swath of investors. Repurchase schedules and terms are important to how interval funds operate, as these funds routinely invest in less-liquid securities that can be harder to sell.

The proposal would give interval fund managers greater latitude when they’re conducting repurchases. Among other things, it would permit the manager to:

• Extend the time period between the fund’s inception and its first repurchase (up to a maximum of two years, compared with about six months today).
• Make more frequent discretionary repurchases.
• Repurchase at monthly intervals.

The proposal would also simplify how funds set the repurchase pricing date, which today must fall within 14 days of the repurchase deadline. In addition, it would relax the requirement to set aside liquid assets between those dates. Currently, funds must have 100% of the repurchase offer in liquid assets during this period.

The SEC said the proposed rules aim to help interval managers better match the timing and magnitude of repurchases with “the liquidity profile of their portfolio.”

How the Proposals Could Affect Investors

As mentioned, these proposed rule changes could affect the outcomes that fund investors experience.

Performance-Based Fees

If fund managers could levy fees on net realized and unrealized gains as the proposal envisions, investors could pay substantially more amid periods of positive capital appreciation.

Performance-based fees are not commonplace in the industry as is. Most funds levy a fixed-percentage management fee, perhaps with some breakpoints tied to the fund’s size, and will often utilize fee waivers as needed to keep a lid on the total expense ratio.

Performance fees haven’t caught on with managers largely because they entail greater complexity and unpredictability. They also have limited upside given that the typical fulcrum adjustment is immaterial compared with the overall fee’s fixed component. To top it off, they’re not marketable, and the odds of beating a costless index aren’t favorable.

But if managers could levy a fee on gains irrespective of how the fund had performed against its benchmark, different story. Here are the rolling 36-month returns before fees since 1996 for one of the biggest active large-growth funds around.

If the manager hypothetically took 20% of returns in each rolling period, it would have added 2.2% to the fund’s expense ratio in the average rolling period. (Note that since these rolling periods overlap, the annual performance fee paid could vary from that average amount.)

To be sure, this illustration is based on the fund’s returns before fees, and there’s no high-water mark to have halted or at least limited performance fees at the relevant times. (A high-water mark prevents a manager from collecting a performance fee until it has recovered prior losses and attained the previous level where a performance fee was last earned.) If the manager and fund boards imposed limits like these, or opted for something less than the maximum 20% performance fee, then the expense drag would obviously be less.

Nonetheless, it’s a potentially big hit to returns for funds where it’s questionable whether they should be levying a performance-based surcharge to begin with. Consider that in this example, the manager would have stood to earn a performance fee in numerous rolling periods where the fund had lagged its index before expenses of any kind had been levied.

The SEC’s proposal includes various measures aimed at bolstering oversight and reporting of any performance-based fees. For instance, funds would begin to separately break out these fees when reporting expenses. And boards would be on the hook to ensure the fees were in shareholders’ best interests, addressing the appropriateness of the fee given the strategy, the fee calculation method, and the adequacy of additional safeguards.

It’s possible performance-based fees could drive stronger alignment between managers and fund investors, buoying returns to a degree that it more than offsets whatever additional costs shareholders incur. But those benefits are highly uncertain.

Interval Fund Repurchases

By contrast, the interval fund proposal could affect investors in more nuanced ways.

The proposal to extend the period between fund inception and the first repurchase would make these funds less liquid. An investor seeking to redeem in this period would have no guaranteed periodic repurchase opportunity. While that’s no different from today at many interval funds, the waiting period would be significantly longer under the proposal.

On the flip side, a proponent could argue the longer redemption waiting period would ensure these funds become fully invested sooner and remain so for longer. This could burnish their performance and afford opportunities to invest in securities that might otherwise be off-limits, such as those that impose stricter redemption requirements.

The proposal’s other key planks—to allow more frequent discretionary repurchases and monthly repurchase intervals—also could be a mixed bag where investors are concerned. On one hand, a monthly interval schedule could help to smooth out redemptions compared with the quarterly schedule that’s the norm. Also, more frequent discretionary repurchases give the manager another tool to meet redemptions when the standard interval schedule doesn’t suffice.

On the other hand, a monthly interval could be at cross purposes with an interval fund’s objective (such as investing in harder-to-access, less-liquid securities) if it’s forced to keep more liquidity on hand to meet more frequent redemption requests. Also, while discretionary repurchases give the manager more leeway, they’re hard to predict and might court the risk that the manager will use its discretion to sell the portfolio’s more-liquid securities, leaving remaining investors holding a very illiquid portfolio.