Published: October 01, 2009
Over the past couple of years, as a result of the turmoil in financial markets, investors’ attitude towards cash as an asset class has gone through a fundamental change. Before the liquidity crisis, cash was generally regarded as the least risky asset class, but events of the past eighteen months, in particular the drying-up of liquidity in money market instruments and the failure of a US-based money market fund in the wake of the Lehman bankruptcy, have served as a timely reminder to investors that cash is not risk free.
As a consequence, money market funds are currently under more scrutiny than ever before, and the onus is on managers to demonstrate that they have a robust investment strategy and process that will be effective in all kinds of market environments. Money market funds operate in a different way from other types of funds, as rather than concentrating on producing a return (often against a defined benchmark), their primary objective is to return capital to investors on demand, which means that their focus is the preservation of capital and the provision of liquidity, with yield as a secondary consideration. Of course there remains a risk that money market funds will not meet this primary objective, particularly when the market is in dislocation.
Investment managers manage this risk through a rigorous investment process. At HSBC, the investment process for our Liquidity fund range is designed to help the funds attain their stated investment objective: ‘to provide investors with security of capital and daily liquidity together with an investment return which is comparable to normal…money market interest rates’. The first part of the objective (‘…security of capital and daily liquidity…’) deals with credit and liquidity risk. It means that the starting point of our process is to constrain our investable universe to those assets that we consider to be secure and liquid. The second part of the objective (‘…an investment return comparable to normal money market interest rates…’) is met by enabling our analysts and managers to seek out value within the investable universe.
We make our internal investment constraints highly dynamic so that we can adapt rapidly to changes.
Looking at the first part of the objective, our investment process manages credit and liquidity risk by imposing two types of constraint on our investable universe: external constraints (i.e., those imposed by rating agents, IMMFA and regulators) and internal constraints (i.e., those imposed by our own Credit and Investment Committee). External constraints comprise a large number of quantitative and qualitative requirements, for example: rating agents’ requirement to invest in A1/P1 paper, IMMFA’s requirement to maintain a WAM no greater than 60 days and the regulator’s requirement to appoint a third-party custodian to safeguard the fund’s assets. These external constraints are reasonably well understood by our investors and so provide them with reassurance that our fund meets minimum industry best practice.
While external investment constraints remain fairly static, changing only very infrequently, we make our internal investment constraints highly dynamic so that we can adapt rapidly to changes in the market environment. This has been particularly important during the market turmoil. For example, our Credit and Investment Committee maintains our Approved Counterparty List, and reviews it regularly. The list outlines our exposure and duration limits for those issuers that we judge to be of good credit. Every issuer on the list is monitored on an ongoing basis by one of our credit analysts, and overseen by the Global Head of Credit. This means that we can supplement rating agency research with our own independent assessment of credit risk, and respond rapidly to changing market conditions. For example, we removed Lehman Brothers from our Approved Counterparty List well before it had been downgraded by the credit agencies. [[[PAGE]]]
In addition, the committee has the authority to impose other constraints on the fund, including constraints that manage liquidity risk (such as minimum liquidity ladders, and maximum shareholder concentrations) and guidelines that manage credit risk (such as diversification requirements). Again, we can adapt these constraints in response to changing market conditions. For example, as secondary market liquidity dried up in 2008, the committee increased the minimum liquidity required to be available to the fund, both overnight and within one week. Finally, the committee monitors key risk metrics on an ongoing basis, including stress testing the impact on the fund’s portfolio of movements in interest rates and spreads, and the effect of redemptions.
These external and internal constraints combine to define an investable universe, which varies in size according to the restrictions imposed as a result of changes in market conditions. The final part of our investment process, then, is to enable the fund manager to seek out value within this universe. Our assessment of value depends on a number of factors, including: our expectation of future rate movements, which will result in the shortening or lengthening of the fund’s portfolio; the shape of the curve for different sectors and issuers, which will result in an allocation between government, financial and non-financial issuers; and the need to meet expected client redemptions (which we are able to monitor closely, since we have direct relationships with all major shareholders in the fund).
Although most money managers have a robust investment process in place, it is not always immediately apparent to potential investors. This means that another area that needs to be addressed is fund disclosure: in order to boost investor confidence in this area of the market, money market funds need to make their objectives, and the process by which they hope to attain them, very transparent. Although money market fund providers operate within very tight guidelines set out by regulators and rating agencies, they still take different positions in credit and duration risk. Fund providers need to capture these differences in risk in easily understood metrics that can be communicated to money market investors in a simple form. For example, fund providers could disclose the weighted average life (WAL, also known as weighted average final maturity, or WAFM) of the fund or its liquidity ladder. At present, potential investors only have the yield of the fund to consider, and this is more closely aligned with return rather than risk.
Recent market events have shown that money market funds are not risk free. In order to be able to provide security of capital and daily liquidity, fund providers need to have an investment process in place which is both robust and dynamic, so that it can respond quickly to changing market circumstances. The most effective way of doing this is to combine external constraints, which are industry standard, with internal constraints which can be adapted more immediately. In addition, fund providers should be transparent about their investment process and provide relevant disclosure to investors.
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