Investors asking the right questions

sTraditionally money market funds have never had a high profile, but the last few months have put paid to that. Instead of investors assuming that all money market funds are born equal, managers are now grilled much more closely about their processes and assets, and far from being a cyclical concern, greater appreciation and understanding of risk amongst investors looks here to stay. Post-Lehman, managers who run funds that strive to maintain a stable and consistent net asset value are keen to promote this feature. In the US, 2a-7 money-market funds regulated by the Securities and Exchange Commission are required to hold debt that matures in 13 months or less, with a weighted average maturity of up to 90 days. The securities must have top short-term corporate debt ratings. It is a model that had been adopted across Europe, and in the current market uncertainty has come into its own. A maturing market “The market in Europe has started to mature and investors have started to distinguish between true money market funds and money market funds that have as their objective to increase yield, which we might call enhanced cash products,” says Hugh Briscoe, product manager EMEA at GSAM International Liquidity Management. “In the US, SEC Rule 2a-7 defines and regulates US money market Funds, but in Europe and Asia there is no equivalent regulation to monitor and guide money market funds. Ucits offers some diversification guidelines in Europe, but they are in the broader context of mutual funds and do not specifically apply to Money Market Funds,” he explains. “Twelve-eighteen months ago investors were not concerned to distinguish between enhanced cash money market funds and AAA-rated principal stability money market funds [as defined by the rating agencies], but events last summer caused investors to look carefully at how they enhance return,” adds Mr Briscoe. One of the triggers was the spectacular collapse of Reserve Primary Fund, a $64.8bn (E51.1bn) money market mutual, which ‘broke the buck’ in September, a phrase used to describe the situation when net asset value falls below $1 a share. It was the first such fund to do so for 14 years. Reserve Primary held $785m in Lehman commercial paper and MTM notes. Standard & Poor’s immediately put nine other funds on watch, suspecting they too held Lehmans paper. In the event, Reserve Primary fell to 97 cents a share, and its management was unable to prop up the fund before halting redemptions, possibly because it lacked the backing of a large institutional owner. “The big banks might be able to swap illiquid assets into other areas of their operations for cash, but this is not likely to be disclosed,” says Mark Klein, manager of Bank of New York Mellon’s Universal Euro fund. Shareholders in the Reserve fund have now filed a lawsuit in the US District court in Manhattan, charging that the fund had failed to follow its stated objective of preserving capital and instead pursued yield by buying Lehman commercial paper. Seeking safer ground Subsequent redemptions from prime funds investing in corporate debt have been massive, as investors sought safer ground, putting big sums into Treasury funds which buy only government bonds. More than $400bn exited the sector in the three weeks after the Reserve Primary Fund crisis, while Treasury-only funds attracted more than $190bn over the same period. Much of the demand for government products has come from European corporate Treasury departments looking for a safe haven and paying particular attention to liquidity. While prime funds have now stabilised in terms of outflows, their liquidity buffers have gone. Some money market fund operators have even faced the prospect of closing funds to halt redemptions or engineering costly bail-outs of their funds. In the current market, the situation has been exacerbated because the secondary market for mortgage bonds and structured credit has all but dried up. Putnam, for example, closed a money market fund to avoid losing investors’ money, not because it held subpar holdings but because high levels of redemptions might have meant forced selling in an illiquid market. Ironically, the pullback of extremely conservative funds from the short term debt markets exacerbated the situation causing credit markets to seize up. In October the Federal Reserve launched a third program to help the sector, funding purchases of up to $600bn (E472.85bn) worth of money market mutual fund assets to help provide liquidity to strained markets. Money market funds should in turn extend the maturities of investments they are making, thereby re-introducing liquidity and stimulating interbank lending. Because by and large money market fund volumes have been growing for years, the need for liquidity has not been tested until recently. The universe has grown rapidly from around E1bn in 1998 to E500bn plus currently. Several managers pay close attention to their clients’ investment strategies, making an effort to build a diversified client base and regularly reviewing it in an attempt to guard against simultaneous redemptions. Waiting for the bottom Much of this money could flow back into equities and commodities when investors perceive the bottom of those markets are in sight. Some funds are more exposed than others to investment-driven clients who are more likely to switch between funds and asset classes. BNY Mellon says a large proportion of its business is corporate Treasury – a client group parking funds to be used at some stage within their businesses. In the current climate corporates are proving keen to park their cash rather than reinvest it. Meanwhile investors are still taking fright and switching out of corporate bond funds into more conservative funds. “The existence of Insticash (BNY Mellon’s stable NAV fund) has accelerated some client decisions to switch out of the Universal fund (a corporate bond fund),” says Mr Klein, “particularly for those clients who can change at the press of a button.” BNY Mellon is also close to launching a Euro sovereign fund with a low yield to tap into clients’ continuing aversion to risk. Arguably, however, Treasury and gilt money market funds are now overpriced, while corporate debt, following the Government bailout of the banks, might be thought of as Government-supported bank stock funds, representing an attractive opportunity. Net yields of Treasuries funds have fallen below 1 per cent, and while net yields on prime money have also tumbled, they remain well above those achieved by funds investing in government securities. The position of these funds could become problematic if yields continue to grind lower. Funds had to contend with very low Fed-funds rates in the deflationary-scare of mid-2003, when Fed funds stood at 1 per cent. This made some money market forgo their fees which would otherwise have wiped out the gross yields on their portfolios. “Cash plus or liquidity plus funds, the tuned up funds with relaxed risk parameters have been out of favour because of the climate,” says Chris Oulton, chief executive officer at Prime Rate. “But once people realise conservative QMMF (qualifying money market funds) do not offer an absolute guarantee they will get their money back at par, they might get a more realistic expectation of risk. These funds may then come back in favour because spreads have widened and while there was not sufficient pick up until the crisis, there may now be sufficient value to compensate [for the risk],” he explains. “Lehman, AIG and the nationalisation of the banks has drawn a strong line under the past and fundamentally changed the investment world,” says Mr Oulton. “A few years ago it would not have been imaginable that Goldman Sachs and Morgan Stanley would put themselves until Fed supervision. These were momentous moves, huge decisions that have changed banking models forever.” “Investors now look at the reporting we send them in detail, examining what kind of assets managers own, and paying attention to liquidity risk which no-one was very aware of previously,” says Guy Lodewyckx, Head of Short Term Fixed Income at Société Générale Asset Management. “This is not going to change in the near future. Investors will continue to scrutinise the assets very carefully,” he adds. “We have also noticed a big pick up in clients challenging the process,” says David Scammell, Rates Fund Manager at Schroder. “There are many more questions about the rigidity of how the fund is managed. It is a very challenging environment because we are losing even big names on the banking front, that were unthinkable a few years ago,” he adds. Similar approaches In general, there are no dramatic differences between the fund managers’ approaches. Most big houses run a credit analysis team and do not invest in a name unless it is on the approved list. “Generally speaking, there’s an element of commoditisation – all the prime funds are rated triple A – so there is a lot of commonality,” adds Mr Klein, who also points out that the industry has pulled together well in the crisis. “The funds are all in the same field, trying to achieve the same thing for client which is preservation of capital, liquidity and yield,” he says. The db x-trackers Eonia Exchange Traded Fund also makes our Top Ten line-up, despite only being launched last summer. Money market ETFs have been very successful in attracting investors with their low all-in costs, a transparent predefined performance and robust structures. “Our Eonia ETF launched in June 2007 was the first money market ETF in Europe and in 17 months it has raised E4.4bn,” says Marco Montanari, Head of Fixed Income ETF Structuring at Deutsche Bank. “In the current market environment some investors are looking for short-term highly rated sovereign bonds but these bonds involve lower yields than in the past due to the strong demand. They also present yields characterised by high volatility due to market conditions. This is why getting an exposure to an overnight predefined rate such as the Eonia one, could be considered as an efficient solution to improve returns and at the same time reduce the related volatility,” says Mr Montanari.