Risk Management in Money Markets:
Are all cash funds created equal?
by Alexander de Giorgio, CFA, Product Manager, Fixed Income, and David Rothon, Portfolio Manager, Northern Trust
Before the events of August 2007, money market funds were generally perceived to be at the safer end of the risk / reward spectrum. Numerous products exist where traditional benefits are to provide capital preservation, high levels of liquidity and then to maximise the yield. For investors with differing risk appetites, the choice of strategy was ample and included everything from stable NAV money market funds to enhanced cash funds and short term bond funds. All were backed by high credit ratings and promised to add minimal risk to an overall asset allocation.
Recent distress in the financial markets has been widespread and the spotlight was focused on money market funds when concerns were raised over the degree of principal protection inherent in funds. The realisation that all money market funds are not the same has highlighted the importance of understanding the risk / return dynamics of differing types of money market funds.
How did we get here?
By taking a step back to understand how the money market universe has developed over the last decade it can be seen that ongoing regulatory changes in the US and Europe, as well as the increasing complexity of corporate cash management, have fuelled a dramatic growth in assets under management in the industry. Money market funds offered an attractive alternative to traditional bank deposits, providing diversification, off balance sheet exposure and access to active investment strategies without sacrificing liquidity.
Recent distress in the financial markets has been widespread and the spotlight was focused on money market funds.
As the demand for such products increased so did the variety. The result was an industry traditionally viewed as a conservative safe haven for cash actually became home to a multitude of disparate strategies ranging from very low risk government treasury funds to more volatile enhanced ‘cash +’ vehicles and short duration bond funds. Yet in many ways this was a positive step for investors. It gave them the ability to parcel out their cash into buckets with different liquidity needs and therefore different risk profiles and allocate to the different strategies accordingly. As long as the risks underlying each type of strategy were clearly defined and monitored investors stood to gain significantly from this efficient re-allocation of capital.
An investor seeking the security of a short-dated government fund would typically expect a lower yield relative to investing in a strategy which has a greater interest rate and credit exposure. However, the previously benign global economic environment spurred investor demand for higher yields from cash portfolios. One avenue to increase yield undertaken by money managers was to increase exposure to securitised products. Securitisation implies there are underlying assets providing the necessary cash flows. Unfortunately several of these products’ underlying investments included sub prime debt. Once the sub prime market collapsed the market for these related instruments froze irrespective of whether or not the program contained such exposures.
Crucially however, the market dislocations have resulted in a significant divergence in investment performance between the various strategies in the money market universe. It has served as a reminder that cash management involves active decision making and therefore robust risk management and a clear understanding of the underlying risks in any investment are critical factors in the potential success of a money market strategy.