When I started in the funds industry in the early 1990s, all unit trusts were, what is called, dual-priced (there were no open-ended investment companies in those days). That meant they operated a bid-offer spread, which included both the spread on the underlying assets and any initial charge from the manager. Whilst many managers quoted bid-offer spreads within the maximum allowed, costs remained high.
The Securities and Investments Board (the ‘SIB’, a forerunner of the FCA) was, at the time, concerned about both these high charges and also the lack of transparency in the unit trust pricing mechanism, and it looked enviously at the single-priced funds (i.e. one price for both purchases and sales) developing in the continental European funds market. Consequently, they asked me to do some work with them, and the then Unit Trust Association, on the potential introduction of single pricing into the UK funds market. This piece of work demonstrated the advantages of single-pricing, but recognised that there were underlying costs to a fund when clients bought and sold units, and if these were not addressed, there would be dilution to a fund’s assets. My recommendation was that managers should be able to charge a dilution levy, which would be paid into the fund for the benefit of all of its clients.
By the middle of the 1990s we saw the introduction of open-ended investment companies in the UK as an alternative to unit trusts and, under the SIB rules, single pricing was mandated. This was later followed by allowing single pricing for unit trusts.
But whilst the concept of single pricing became well established within the authorised UK fund industry, the problem of equity between unitholders remained. If clients were able to purchase or sell units at a single price without any adjustment for the underlying costs of that trade, then there would be long-term dilution of the fund’s assets. But how could this be rectified, without going back to the old dual-pricing regime?
Fast forward to today, and the industry has settled on two solutions, dilution levies and swinging-pricing.
Dilution levies are similar to what I proposed back in the early 1990s, a percentage charge added to either the cost of buying or the cost of selling units, and any money raised through this would be paid into the fund to compensate it for the costs of those trades. But that is where the simplicity ends. The fund only suffers a cost when it has to buy or sell underlying investments to match the client trade. What happens if a client purchase is offset by a similar client sale, or if the purchase or sale is small enough not to require any portfolio adjustment? If the former case, where client purchases and sales are broadly matched, is the norm for a fund, then instead of dilution the fund will experience concentration, i.e. an increase in assets paid for by client transactions, and for the benefit of the longer-term clients. One solution is to charge a dilution levy only on larger transactions, but that discriminates institutional clients against the smaller retail ones.
To counter these objections to dilution levies, a single swinging price was developed. This meant that the pricing was still single, but could be adjusted upwards if there were net purchases on any particular day, and downwards if net sales. By this, any cost of readjusting the portfolio was met by a higher purchase or a lower sale price.
Whilst sounding simple, swinging prices had their own complications. Again, as with dilution levies, institutional clients might find that they were subsidising retail clients, and swinging prices will also cause issues with price volatility and month-end performance calculations. One way that partly deals with these issues, and used by most managers, is to operate semi-swinging pricing, which is to swing the price only when the net purchases or sales exceeds a previously agreed threshold.
The fund industry has now largely reached a consensus on how funds should be priced. But it is important to remember that both dilution levies and swinging prices have their limitations. Whilst they can manage costs of client trades on a fair basis, they are less useful when managing, or trying to control, portfolio liquidity. Among recent examples was, in March 2020, the time when the industry suffered significant redemptions, together with widening dealing costs on the underlying portfolios; a situation which was then supplemented by ongoing deliberations about how to manage illiquid hard-to-price retail funds, such as those investing in real estate. So this is not the end of it: there will always be times when the methodology is tested …… and the debate re-opens.