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Money Market Funds: A liquid asset in volatile markets
Normally, the summer is a time for relaxation and enjoyment... but not the summer of 2007!! The fallout and repercussions of the turmoil in financial markets continue, and as yet, there is no light at the end of the tunnel. However, we at the Institutional Money Market Funds Association (IMMFA) continue to have a positive outlook.
Not all money market funds have escaped unscathed from the turmoil which has been affecting global economies since last summer, but it is important here to draw the distinction between the different types of money market funds that are available. Some funds are managed with the primary objective of producing an enhanced yield for investors whilst still offering an element of capital security and liquidity. For other money market funds, the yield is of secondary importance when compared with the primary twin objectives of preservation of capital and access to that capital upon demand.
It is important to draw the distinction between the different types of money market funds that are available.
IMMFA only represents the latter style of money market fund - these funds are often referred to as ‘liquidity funds’, ‘treasury-style money market funds’, and now increasingly as ‘422 Funds’ (after the relevant asset valuation section of the CESR guidance associated with the Eligible Assets Directive). Irrespective of the nomenclature for these funds, the reality of the situation is that there are significant differences in the way these funds are managed when compared against the ‘enhanced’ - or ‘investment-style’ money market funds. For this reason, IMMFA fully supports a move to a pan-European definition of a money market fund, similar to that in operation in the US under SEC rule 2a-7.
The impact of the market turmoil on money market funds depends upon the type of money market fund in question. Let me start with ‘enhanced’ money market funds, which have received more press coverage and attention, albeit sometimes without any distinction between fund types being made. These funds are designed to provide the investor with a headline rate of return, whilst also offering security and liquidity. Increasing use had been made of structured products - such as asset backed securities (ABS) - to provide additional yield to these portfolios. Some of these funds achieved a triple-A rating from one or more of the independent credit rating agencies. Irrespective of any triple-A rating, the susceptibility to market volatility and liquidity tightening was not evident in benign markets. Consequently, investors were prepared to accept a notional increase in risk in return for a more attractive yield.
At the onset of the turmoil, the liquidity risk in these funds became immediately apparent. Difficulties in valuing assets occurred when secondary markets disappeared, and with ‘forced-sales’ into illiquid markets, these funds were increasingly subject to significant reductions in fund values. In some notable instances, parental support was sought or the fund was simply wound up.
The success of 422 funds
In contrast, 422 Funds have generally performed very well. Funds under management have increased to record highs, both in Europe and in the equivalent US fund type. In Europe, funds reached €393 billion at the end of March 2008, an increase of over €75 billion since June 2007.
The success of 422 Funds is in no small part due to the investment structures of these funds. Regulatory obligations require the funds to have a weighted average maturity (WAM) for interest risk-management purposes of no more than 60 days, and to purchase no instrument which has a fixed interest - or interest reset period - of more than 397 days. These funds are therefore all short-term in nature, with most funds operating with a WAM of approximately 40 days. At the onset of the financial turbulence, fund managers were able to respond quickly to the crisis by changing the composition of the assets within the fund to build up a strong supply of daily liquidity. With a regular supply of maturing assets, this was achieved without having to resort to any ‘forced-selling’.
The underlying portfolios could then be quickly altered to ensure the principal objectives of preservation of capital and liquidity continued to be met at all times. In recognition of the growing nervousness of investors as the crisis deepened, 422 Funds simply increased the proportion of assets held on overnight deposit, or as certificates of deposit, to ensure the ability to liquidate investments same-day was retained for all investors.
Another key differentiator for these funds is their ability to value assets on an amortised basis. Whilst other funds can utilise this methodology for components of the portfolio, it is only 422 Funds which can value both the fund and all underlying components on this basis (as governed by the Eligible Assets Directive and associated CESR guidance). Using this methodology, the asset value is extrapolated on a straight-line basis from the purchase price at a premium or discount to par to the price at maturity of par. Regular comparisons with the mark-to-market price are made at fund and instrument level, with escalation procedures in operation to ensure material differences are acted upon. However, the directors of the fund have discretion over the action which should be taken upon any divergence in the two pricing methodologies, provided the relevant individuals make the decisions which should be in the best interests of investors in all instances.