Protect investor capital

The volatility in the equity and fixed-interest markets that has continued since early summer has prompted investors to seek a safe haven for at least part of their portfolios. One beneficiary of this has been money market funds in Europe. Daniel Salama, product specialist at BNP Paribas Asset Management, says the company attracted e1bn of inflows into its AAA money market funds in just a two-month period over the summer. But flows into enhanced cash funds have fared less well since the start of the credit crunch. The attraction of money market funds to investors is that they are designed to protect their capital while potentially being able to deliver higher levels of income than cash deposits. They are open-ended, collective investment funds that hold short-term debt instruments. Funds are diversified across these instruments while providing investors with daily trading. This allows investors to redeem money without having to provide prior notice for withdrawals. Income in money market funds is accrued on a daily basis. Constant net asset value funds will pay this income to investors, or use it to buy more units in the fund at the end of the month. Under accumulating net asset value funds, the income is not distributed. The income is reflected in a growth in the value of the fund’s shares. It is estimated that at the end of August 2007, money market funds in the US had $2,700bn (e1,860bn) in assets under management. In contrast, managers who are members of the Institutional Money Market Funds Association (IMMFA) had $425bn (e290bn) in assets under management in their European-domiciled money market funds at the end of June 2007. Of these assets, £65.8bn (e94.7bn) were in sterling funds, e52.8bn in euro funds and $221.4bn (e152.5bn) in dollar funds. The size of the market is not the only difference between the US and European money market funds. In 1983, the US Securities and Exchange Commission (SEC) introduced regulations governing money market funds under the Investment Companies Act 1940. These regulations are known as the SEC rule 2a-7 and set parameters governing credit, market and operational risk. For example, paper held by money market funds cannot exceed 90 days. There are no such regulations governing funds domiciled in Europe. But the IMMFA introduced a code of practice in February 2003 and funds have to comply with the criteria set by the rating agencies Fitch, Standard & Poor’s and Moody’s to be granted AAA rating. The instruments that AAA funds invest in include certificates of deposit, commercial paper, floating rate notes, repurchase agreements, short-term government securities and time deposits. Mr Salama explains that the average duration or maturity of instruments held by AAA funds must be 60 days and no paper in the portfolio can have a longer duration than 397 days. While there are no regulations in Europe, funds are subject to the Ucits III regime. These regulations include a maximum allocation to a single issuer of 5 per cent of the fund’s assets, although this is 10 per cent in some jurisdictions. Mr Salama says that the rating agencies permit a maximum allocation of 25 per cent to very short maturity instruments, which is effectively overnight paper. But under the Ucits III regulations, there is a maximum allocation of 20 per cent. A key allocation decision for funds, of course, is the proportion of assets that have to be held in overnight paper to meet the redemption requirements of investors. Money market funds have to provide daily liquidity for investors. Enhanced cash funds are not subject to such stringent criteria. These are not AAA funds that try to generate a higher return by investing in longer dated paper or by going down the credit scale. Enhanced cash funds have been popular among continental European investors, such as in France. Rainer Habisch, who heads the European institutional sales team for money market products at DeAM/DWS, says there has traditionally been a difference between the Anglo Saxon and European approaches to money market funds. “The US and Anglo Saxon funds use the SEC 2a-7 definition of money market funds, offering a protection of principle through a stable net asset value and AAA fund ratings from different rating agencies. “But in German-speaking countries in continental Europe, and Italy and Spain, investors are looking for higher returns from money market funds. The difference is driven by the fact that continental European investors use bank deposits that offer a fixed rate of return over a specific period of time. Therefore, investors are looking for investments that provide similar or higher returns with some kind of protection, but not necessarily an AAA rating,” explains Mr Habisch. “The DWS Institutional Money Plus fund has been designed as an alternative to those fixed-term deposits. It offers a yield path concept with a monthly predefined rate of return. At the moment, the yield path has been set at 4.08 per cent, which is valid until 4 December 2007. The advantage over fixed-term bank deposits and products is that investors have a broadly diversified investment and can invest and redeem from it at any time. Therefore, liquidity is better, which appeals to European investors,” he says. The fund has an A1+ guaranteed fund rating from S&P. Its return is accumulated to the net asset value on a daily basis. On top, DWS Investments provides a half-yearly adjusted guarantee, valued at e12,796 on 1 July 2007. This price is guaranteed on 31 December 2007. “There is little risk of losses, but some clients require the guaranteed element,” says Mr Habisch. “The advantage of the fund is the yield path concept. Since launch in 1999, the fund has always paid its predefined yield path. Any out-performance of the declared return is retained. For example, if the next 30 days produces a return of 4.10 per cent, 0.02 per cent is retained and placed into a buffer account. “This buffer account is then used to take out volatility in returns during periods of turmoil, such as over the summer, and to produce an almost linear return overall,” says Habisch. As well as the traditional money market assets, the DWS Institutional Money Plus fund can also use more “dynamic” components, although they comprise a small part of the portfolio. “They include asset-backed securities and special-purpose vehicles, as well as yield and credit spread strategies and currency exposure through calls and puts,” says Mr Habisch.

‘In August, duration in the fund was an average of seven days, but this has risen to 24 days’ - Daniel Salama, BNP Paribas	‘There is little risk of losses, but some clients require the guaranteed element’ - Rainer Habisch, DeAM/DWS
‘We did not own either of these types of asset. These were more likely to be held by enhanced cash type funds’ - Guy Lodewyckx, SGAM	‘When investors consider money market funds, they think of safety. During the credit crunch, AAA money market funds delivered positive returns’ - Jason Singer, Goldman Sachs

Jason Singer, head of international cash portfolio management at Goldman Sachs Asset Management (GSAM) for Europe, the Middle East and Asia, says the market turmoil of the summer has highlighted the importance of investors understanding the composition of money market portfolios and the instruments and maturity they can and cannot invest in. “When investors consider money market funds, they think of safety,” says Mr Singer. “During the credit crunch, AAA money market funds delivered positive returns. “Some investment-style money market funds have suffered losses due to exposure to asset-backed securities. The issue is not necessarily that these funds have had exposure to subprime paper, but that the market is not differentiating between the different qualities of asset-backed securities paper than can be held in these funds. “A key fact was that funds are usually measured on their interest rate duration, not their sensitivity to spread duration, which have affected returns since the beginning of the liquidity event that began in July 2007.” The difference is reflected in the fact that the first goal of money market funds is to preserve investors’ capital, says Mr Singer. “The second goal is liquidity and the third goal is a good return. These goals are reversed for investment-style money market funds. Some investors want to try to improve their returns by using investment-style money market funds, but they have to understand that these funds are different from stable NAV money market funds.” Over a one-year period, the difference in performance of the 10 largest money market funds sold cross-border in Europe is less than 1 per cent. Over five years, the spread between the best- and worst-performing funds is more than 4 per cent, reflecting an annual difference of close to 1 per cent. It is difficult to compare the performance of the Merrill Lynch ILF Inst Liq GBP fund with other funds because it is denominated in sterling, whereas the other funds are in euros. A number of factors contribute to this difference in performance between money market funds. Mr Singer highlights duration, credit quality and security selection as among the factors driving the performance of money market funds. He adds that investors should also evaluate the commitment of asset managers to money market funds. “We have $175bn in money market funds,” says Mr Singer. “We have been managing money market funds for 26 years. It represents a significant portion of our total assets under management. It is a very important asset class to GSAM.” Guy Lodewyckx, manager of the SGAM Money-Market Euro fund, says the impact of credit quality and issuance selection was seen most particularly over the summer when the value of floating rate bonds and asset-backed securities were particularly badly hit. “We did not own either of these types of asset. These were more likely to be held by enhanced cash-type funds.” Mr Salama says that in addition to stock selection, performance can be enhanced by the manager’s ability to anticipate the market environment. “For example, with interest rates falling we have kept a longer duration than some funds to enhance returns. There is a lag effect on the credit curve. “In August, duration in the fund was an average of seven days, but this has now risen to 24 days. Traditionally, the average duration has been 30-to-35 days. We never go as high as 50 days, even though we are permitted to have an average of 60 days. “But we are conservative in our view of credit quality because we are concerned that the effects of the credit crunch have not yet been fully felt. To this end, we do not use asset-backed securities and are extremely cautious with asset-backed commercial paper. We also use interest rate swaps to actively manage the curve.” Another significant driver behind performance are fees, says Mr Lodewyckx. “This can create a difference of one, two or three basis points a year.”