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Proposed rule 22e-4 envisions a two-pronged liquidity risk assessment and risk management process, whereby a fund would be required to assess its liquidity risk, based on certain specified factors, and then develop a liquidity risk management program tailored to the fund’s liquidity risk.262 _{Here we discuss the liquidity risk assessment portion of this process.}

The requirements we are proposing for the fund’s management of the risks identified by this assessment are discussed in a later section of the release.263 _{Proposed rule 22e-4(b)(2)(iii) would}

require each fund to assess the fund’s liquidity risk, considering certain specified factors that are discussed in more detail below. We compiled these factors based, in part, on staff outreach to funds and third-party service providers who assess liquidity risk on behalf of funds. To the extent that funds currently conduct liquidity stress tests, we understand that these stress tests commonly incorporate many of the proposed factors (or functionally similar factors).264 _The

proposed liquidity risk factors also incorporate considerations that we believe have historically contributed to liquidity risk in open-end funds.265

262 _{To the extent that liquidity risk differs among each series of an investment company, each series would be}

required to adopt a liquidity risk management program whose liquidity risk assessment and management elements are distinct from other series’ programs. See supra paragraph accompanying notes 114-115.

263

See infra sections III.C.3 – III.C.5.

264 _{See supra notes 101, 257 and accompanying text.}

265 _{See Guidelines Release, supra note 4 (noting that funds should consider cash flows into specific investment}

108 The proposed rule would require each fund to take the following factors into account, as applicable, in assessing the fund’s liquidity risk:

o Short-term and long-term cash flow projections, taking into account the following considerations:

 Size, frequency, and volatility of historical purchases and redemptions of fund shares during normal and stressed periods;

 The fund’s redemption policies;

 The fund’s shareholder ownership concentration;

 The fund’s distribution channels; and

 The degree of certainty associated with the fund’s short-term and long-term cash flow projections

o The fund’s investment strategy and liquidity of portfolio assets; o Use of borrowings and derivatives for investment purposes; and

o Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.

This list is not meant to be exhaustive. In assessing its liquidity risk, a fund may take into account considerations in addition to the factors set forth in proposed rule 22e-4(b)(2)(iii). For example, if a fund elects to conduct stress testing266

to determine whether it has sufficient liquid assets to cover different levels of redemptions, a fund should consider incorporating the results of this stress testing into its liquidity risk assessment. However, a fund would be required to consider, as applicable, the proposed rule 22e-4(b)(2)(iii) factors as a minimum set of considerations to be used in assessing its liquidity risk. For this reason, a fund that elects to conduct stress tests may wish to review the factors and parameters it uses to construct scenario analyses concerning the adequacy of the fund’s portfolio liquidity, and update these factors and

109 parameters to reflect the proposed liquidity risk assessment factors. We believe that stress tests that incorporate the proposed factors, though not required, could be particularly useful to a fund in assessing its liquidity risk.

We recognize that some of the proposed factors may not be applicable in assessing the liquidity risk of certain funds or types of funds. For example, we recognize that certain

considerations that the proposed rule would require a fund to consider in assessing its cash flow projections (e.g., shareholder ownership concentration, and the fund’s distribution channels) would generally be more applicable to mutual funds than to ETFs. To the extent that a proposed factor is not applicable to a particular fund, the fund would not be required to consider that factor in assessing its liquidity risk.

Below we provide guidance on specific issues associated with each of the proposed liquidity risk assessment factors. We also request comment below with respect to each of the proposed factors, as well as guidance regarding each factor.

a. Cash Flow Projections

A fund’s cash flow (the amount of cash flowing either into or out of the fund) is important in determining whether the fund will have sufficient cash to satisfy redemption requests.267 _{Cash flow projections thus directly affect a fund’s liquidity risk.}268 _{As discussed}

below, we believe that several factors influence the extent to which a fund’s cash flow profile

267 _{See, e.g., Invesco FSOC Notice Comment Letter, supra note 35, at 11(“Cash inflows from sources such as}

gross subscriptions (including reinvested dividends on fund shares), dividend and interest payments on portfolio securities and maturities of debt securities held in portfolios do help manage fund level liquidity and are taken into account by portfolio managers as part of their liquidity management.”); ICI FSOC Notice Comment Letter, supra note 16, at 18 (“Managing liquidity as part of overall portfolio management is a dynamic process requiring fund managers to make daily adjustments to accommodate cash inflows and outflows. . . Portfolio managers and traders typically receive data on cash flows at least daily and thus have a strong sense of whether additional actions (including the sale of portfolio holdings) would be needed to meet redemption requests or otherwise adjust a fund’s liquidity profile.”).

110 could indicate or contribute to the fund’s liquidity risk. Proposed rule 22e-4(b)(2)(iii)(A) thus would require a fund to consider these factors when evaluating its liquidity risk. In general, we believe that the better a fund’s portfolio and risk managers are able to predict the fund’s net flows, the better they will be able to measure and manage the fund’s liquidity risk.269

Predictability about whether periods of market stress or declines in fund performance generally lead to increased redemptions of fund shares is particularly significant, as careful liquidity risk management during these periods could prevent the need to sell less-liquid portfolio assets under unfavorable circumstances, which in turn could create significant negative price pressure on the assets and, to the extent the fund continues to hold a portion of those assets, decrease the value of the assets still held by the fund at least temporarily.270

A fund would be required to consider the size, frequency, and volatility of historical purchases and redemptions of fund shares, during both normal and stressed periods, when considering its cash flow projections.271 A fund whose inflows generally correspond to its outflows in terms of timing, size, frequency, and response to market events will likely be able to use cash received from purchases to pay redeeming shareholders, which decreases the fund’s

269

See, e.g., Gordon J. Alexander, Gjergi Cici & Scott Gibson, Does Motivation Matter When Assessing Trade Performance? An Analysis of Mutual Funds, 20 REV. OF FIN.STUD. 125 (Jan. 2007) (noting that

unexpected investor flows may force managers to rebalance their portfolios to control liquidity, and that these liquidity-related trades should underperform trades motivated by valuation beliefs).

270

See, e.g., supra note 54 and accompanying paragraph; Coval & Stafford, supra note 51 (noting that fire sales can be anticipated based on past flows and returns); Peter Fortune, Mutual Funds, Part I: Reshaping the American Financial System, NEW ENGLAND ECON.REV. (July/Aug. 1997), at 66-67, (“Fortune”), available athttp://www.bostonfed.org/economic/neer/neer1997/neer497d.htm (positing that funds with insufficient liquidity to meet redemption requests following a significant decline in stock prices will need to sell securities in a declining market, making the funds more sensitive to price fluctuations); 1987 Market Crash Report, supra note 54, at III-16 – III-26, IV-1 – IV-8 (discussing mutual fund selling behavior during the October 1987 stock market crash, and in particular the selling of three mutual fund companies, whose heavy selling of assets to meet significant redemptions “accounted for approximately one quarter of all trading on the NYSE for the first 30 minutes that the Exchange was open” on October 19, 1987 and that such selling had “a significant impact on the downward direction of the market”).

111 liquidity risk. Funds whose net flows are relatively less volatile in terms of size and frequency will likely entail less liquidity risk than similar funds with more volatile net flows, because funds with less flow volatility can better plan how to meet fund redemptions and thus will be less likely to need to sell portfolio assets in a manner that creates a market impact in order to pay redeeming shareholders.272 A fund should generally review historical purchases and redemptions of fund shares across a variety of market conditions in order to determine how the fund’s flows may differ during stressed and normal periods (keeping in mind that historical experience may not necessarily be indicative of future outcomes, depending on changes in market conditions and the fund’s particular circumstances). In particular, if outflows are greater, more frequent, or more volatile during stressed periods, this could exacerbate the fund’s liquidity risk.273 A fund may find it instructive to understand when its highest, lowest, most frequent, and most volatile

purchases and redemptions occurred within various time horizons, such as the past one, five, ten, and twenty years (as applicable, considering the fund’s operating history). In addition to

considering its own historical flow data, a fund, particularly a fund without a substantial operating history, may wish to consider purchase and redemption activity in funds with similar investment strategies. Consideration of similar funds’ purchases and redemptions could show whether the fund’s historical flows are typical or aberrant compared to those seen in similar funds and assist new funds in predicting flow patterns.

A fund may wish to evaluate whether the size, frequency, and volatility of its shareholder flows follow any discernable pattern. For example, patterns in shareholder flows have been

272 _{See, e.g., Thomas M. Idzorek, James X. Xiong & Roger G. Ibbotson, The Liquidity Style of Mutual Funds,}

68 FIN.ANALYSTS J. 38 (2012), at n.4, available at

http://corporate.morningstar.com/us/documents/MethodologyDocuments/ResearchPapers/LiquidityStyleOf MutualFunds.pdf (noting that funds with less volatile fund flows can afford to hold more illiquid stocks because they can accommodate redemptions with the liquid portion of their portfolios).

112 observed relating to seasonality,274 shareholder tax considerations,275 fund advertising,276 and changes in fund performance ratings provided by third-party rating agencies.277 A fund’s investment strategy also could contribute to its shareholder flows: for instance, we understand that certain investors tend to trade in and out of ETFs with index-based strategies frequently because they invest in these ETFs for hedging and/or short-term trading purposes.278

274 _{See, e.g., Mark J Kamstra, et al., Seasonal Asset Allocation: Evidence from Mutual Fund Flows}

(Dec. 2013), available athttp://www.bus.umich.edu/ConferenceFiles/2014-Mitsui-Finance-

Symposium/files/Kramer_Seasonal_Asset_Allocation.pdf (“[W]e find that aggregate investor flow data reveals a preference for U.S. money market and government bond mutual funds in the autumn, and equity funds in the spring, controlling for the influence of seasonality in past performance, advertising, liquidity needs, and capital gains overhang on fund flow. This movement of large amounts of money between fund categories is correlated with a proxy for variation in risk aversion across the seasons, consistent with households’ revealed preferences for safer investments in the fall, and riskier investments in the spring.”); Hyung-Suk Choi, Seasonality in Mutual Fund Flows, 31 J. OF APPLIED BUS.RESEARCH 715

(Mar./Apr. 2015), available at

http://www.cluteinstitute.com/ojs/index.php/JABR/article/viewFile/9162/9156 (“January is the month when equity funds experience the largest net cash flows and December is the month with the smallest cash flows.”).

275 _{See, e.g., Woodrow T. Johnson & James M. Poterba, Taxes and Mutual Fund Inflows around Distribution}

Dates, NBER Working Paper 13884 (Mar. 2006, rev’d Mar. 2008), available at

http://economics.mit.edu/files/2512 (“Johnson & Poterba”) (finding a “modest” decline in inflows into mutual funds by taxable investors prior to a capital gains distribution date); Brad M. Barger & Terrance Odean, Are Individual Investors Tax Savvy? Evidence from Retail and Discount Brokerage Accounts, 88 J. OF PUB.ECON. 419 (Jan. 2004), available at

http://faculty.haas.berkeley.edu/odean/papers%20current%20versions/areindividualinvestorstaxsavvy_2003 .pdf (observing tax losses being related at greater rates than gains only in the month of December).

276 _{See, e.g., Murat Aydogdu & Jay W. Wellman, The Effects of Advertising on Mutual Fund Flows: Results}

from a New Database, FINANCIAL MANAGEMENT (Fall 2011), available at

http://onlinelibrary.wiley.com/doi/10.1111/j.1755-053X.2011.01161.x/epdf (finding significant differences in the effectiveness of mutual fund advertising to attract inflows (e.g., smaller funds received significant inflows due to advertising, while “flagship” funds did not attract inflows as a result of their

advertisements)).

277

See, e.g., Diane Del Guercio & Paula A. Tkac, Star Power: The Effect of Morningstar Ratings on Mutual Fund Flow, 43 J. OF FIN. AND QUANTITATIVE ANALYSIS 907 (Dec. 2008), available at

http://www.jstor.org/stable/27647379?seq=1#page_scan_tab_contents (finding that certain changes in performance ratings (rather than changes in the underlying fund performance) have a substantial influence on retail investors inflows into and outflows from mutual funds).

278 _{See, e.g., 2015 ICI Fact Book, supra note 3, at 13 (“Investment managers, including mutual funds and}

pension funds, use ETFs to manage liquidity—helping them manage their investor flows and remain fully invested in the market. Asset managers also use ETFs as part of their investment strategies, including as a hedge against their exposure to equity markets.”); see also Izhak Ben-David, Francesco A. Franzoni &

Rabih Moussawi, Do ETFs Increase Volatility?, NBER Working Paper No. 20071, at 12, available at

http://www.nber.org/papers/w20071.pdf (“Theoretical support for this conjecture comes from Amihud and Mendelson (1986) and Constantinides (1986), who propose that investors with shorter holding periods self-

113 Furthermore, a fund may wish to take into account its assets in assessing historical flow data, since smaller funds may experience greater flow volatility.279

While historical redemption patterns are an important factor in assessing cash flows, a fund should be cognizant of the limitations of using past flow history to assess future cash flow needs. Therefore, a fund would be required to take into account other factors when considering cash flow projections, including its redemption policies.280 Specifically, we believe a fund should generally consider the disclosures in its prospectus or advertising materials regarding the time period in which it will pay redemption proceeds (or endeavor to pay redemption

proceeds),281 _{and whether its redemption policies vary based on the distribution channels the fund}

employs. A fund whose policies require it to pay redeeming shareholders on a next-day basis could find itself with fewer options for managing high levels of redemptions than a fund that is bound only by the redemption timing requirements of rule 15c6-1. To illustrate, when a fund that pays redemption proceeds within one day receives a large redemption request and a fund that pays redemption proceeds within three business days pursuant to the timing requirements of rule 15c6-1 receives a redemption request of the same size, the first fund must satisfy the full request within one day, whereas the second fund has more time to space out the sale of portfolio assets in order to satisfy the redemption request. Even though the shareholder flows of the first

select into assets with lower trading costs. Atkins and Dyl (1997) find support for this conjecture by

showing that securities with lower bid-ask spread have higher trading volume. These theories and empirical evidence suggest that, due to the low trading costs of ETFs, a new clientele of high-frequency investors can materialize around the newly created securities. This clientele would not trade the less-liquid underlying assets if ETFs were not present.”).

279 _{See infra notes 726 and 727.} 280 _{Proposed rule 22e-4(b)(2)(iii)(A)(2).} 281

See Item 6(b) of Form N-1A (requiring a fund to briefly identify the procedures for redeeming shares); proposed amendments to Item 11 of Form N-1A (requiring funds to disclose the number of days in which a fund will pay redemption proceeds to redeeming shareholders, and explain if the number of days differs by distribution channel); infra section III.G.1.a (discussing proposed amendments to Item 11 of Form N-1A).

114 and second fund are identical, the redemption policies of the first fund magnify its liquidity risks by requiring that the fund pay redemptions quickly.282 An ETF that typically pays redemption proceeds in kind should generally also consider that it has reserved the right to transact with authorized participants in cash, the circumstances in which it anticipates that it would pay redemption proceeds in cash, and how these policies impact its cash flow projections.

A mutual fund also would be required to consider its shareholder ownership

concentration as a factor affecting its cash flow projections.283 If a mutual fund’s shares are concentrated in a relatively small group of shareholders, one shareholder’s redemptions of fund shares could result in considerable cash outflows from the fund.284 _{This in turn could increase}

the mutual fund’s liquidity risk if the fund does not have procedures in place to manage large redemptions, particularly if the fund were to encounter unexpected redemptions from a large shareholder. For these reasons, we believe a mutual fund should consider the extent to which its shareholder concentration affects its liquidity risk, particularly taking into account other factors that could magnify shareholder concentration-related liquidity risk (e.g., if a fund has an

investment strategy that attracts shareholders who trade based on short-term price movements, shareholders could be more likely to redeem precipitously, and resulting unexpected redemptions by a shareholder with a large ownership stake could cause significant liquidity stresses to the fund).

282 _{See supra note 270.}

283 _{Proposed rule 22e-4(b)(2)(iii)(A)(3).} 284

We note that a relatively concentrated fund shareholder base may make it easier for funds to communicate

with those shareholders about their anticipated future redemptions, and thus plan liquidity demands. However, those shareholders are under no legal obligation to forewarn the fund of their redemptions and so, particularly in times of stress, may not do so.

115 There are multiple ways that a mutual fund’s distribution channels could affect its cash flows (including the predictability of the fund’s cash flows), and the proposed rule would require a mutual fund to consider this factor in evaluating its cash flows and related liquidity risk.285 First, a mutual fund’s redemption practices could depend on its distribution channels. For example, mutual funds that are sold through broker-dealers will have to meet redemption