Published: August 01, 2009
by François Masquelier, Chairman, ATEL (Association des Trésoriers d’Entreprises du Luxembourg) and Philippe Debatty, CAIA, Managing Director, Alternative Advisers S.A.When investing surplus liquidity, the main objective of a corporate treasurer is to guarantee recovery of the principal sum – unfortunately no simple matter in the current market. A treasurer will have seen the limitations of rating agencies. A triple “A” rating is an “extra” guarantee, but not enough for an investor. The guidelines set by the French market regulator “AMF” also seem insufficient to provide assurance about the quality of an investment. This problem does not therefore come down solely to the Anglo-Saxon classification “Treasury-Style Money Market Funds (MMF)” versus “Investment Style MMF”. The idea behind the analysis conducted with the help of Alternative Advisers was to assess the inherent risk in each of a client’s portfolio funds, thus going beyond the simple analysis of accounting treatment alone, by relying on multi-factor analyses.
A money market fund is exposed to two types of risk: the interest rate risk, which can fluctuate to a limited (but real) extent, and the counterparty risks which – during a period of crisis such as the situation during autumn 2008 – can become enormous. We believe it would be helpful to study this second risk type as even if a rating agency specifically targets the credit risk, the score awarded does not prevent the inherent risk for the MMF. [[[PAGE]]]
Fund pooling reduces the impact in the event that the risk arises, but rather than eliminating it, it conversely increases it. Investing in a fund means “outsourcing” its management to an independent professional (subcontractor) and diversifying the risks in order to reduce the potential impact.
This method can thus be a helpful decision-making tool to complement the process of selecting a monetary fund. The analysis can be conducted regularly, on a random basis, to “scan” the investment portfolio. The consultant offers to provide global “top-down” classification reports on the MMF, in terms of risk quality. In the current economic climate and taking into account the prevailing volatility, such a tool could help support a company’s short-term investment policy. After all, you can never be too careful when it comes to entrusting your money to others.
The current financial crisis has affected every sector of the financial management industry. In most cases, however, the movements in financial assets, although extreme, correspond to market shocks which have already happened before (even if we have to go quite far back in time). Traditional methods of risk measurement (analysed in a mean-variance context, for example) could have been used to discover and classify the risks in advance. The greater the risks taken ex-ante (emerging shares, high-yield debt), the more painful the consequences today. Whatever the case, we can now see that we are currently experiencing a “reality check”, which takes the form of a bursting of bubbles.
In contrast to the risk ladder, other private and institutional players seeking a risk-free investment have put their money into money market funds. Yet (and here lies the rub), the financial crisis has also affected the performance of some of these MMFs, while the traditional risk measurement methods did not enable the advance detection of a possible reduction in their value. Consultation of the majority ratings and even the use of official classifications did not provide the sought-after security either!
Indeed, we have recently witnessed considerable falls (largely beyond the materiality level) in the fair values of certain MMF, even though they were classified as “Monetary Euro UCITS” and given 5-star ratings by “Morningstar”. The explanation for this fall can be found simply in the contents of the portfolio and sometimes in the default on payment of one of its underlying securities.
It is clearly time to face the fact that the rating and classification of money market funds is no longer enough to give an investor the prior objective security which he might expect. Moreover, even the name “money market fund” is sometimes used wrongly.
This is why some professional associations recommend using proper segmentation of the range of money market products, by clearly differentiating between pure, “very short-term money market funds”, i.e. “treasury-style” funds, and those with a longer time span, investment-style” funds. Indeed, being considered “cash & cash equivalent” in the sense of IAS 7 is now necessary, but not sufficient. [[[PAGE]]]
Meanwhile, because the information about how the fund portfolios are made up is not always available and analysing them is no simple matter, a solution must be found in order to make these investments secure.
Reliance on multi-factor analyses provides us with a few solutions.
Multi-factor models offer a better understanding of the risks. They are useful in:
They are determined by the following equation:
These models are used most frequently in hedge fund analysis, to simplify the understanding of the risks involved in such investments and the factors behind their performance. They are especially necessary here because the breakdown of the portfolios is not generally known. However, even if the details are known, a treasurer cannot necessarily validate their quality.
Applying these models to an analysis of MMFs should give us an answer to our problem. To do this, we must first identify the risks to which money market funds are exposed. The second stage is then to identify the explanatory factors behind each of these risks. The method involves “X-raying” the EONIA (the traditional benchmark for “pure” money market funds in the Eurozone) risk factors and comparing them with those of the funds analysed.
To conduct our study successfully, we selected twelve “pure” monetary UCITs which included funds governed by the laws of Luxembourg, France and English-speaking countries, with stable or combined daily NAV. Each of these money market funds is classified as a regular treasury-style fund or “fonds monétaire euro”, and its investment strategy is to achieve regular daily performance in relation to its reference index, the EONIA. Also, at the time of the study, each fund had a rating of Aaa, MR1, MR1+ or 5-star Morningstar rating. The study was conducted between 2 January 2008 and 30 September 2008.
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There are potentially two types of risk to which money market funds expose themselves in order to meet their management targets: interest rate risk and credit risk.
The explanatory factors used to measure interest rate risk are the following indices: the 1 week EONIA swap, the short-term rate spread, the 1-3 year EuroMTS and the inflation-linked EuroMTS.
The explanatory factors used to measure the credit risk are the following indices: the Barclays Euro-Aggregate AAA, AA, A, Baa, Corporate, Finance and Euro High Yield, and the 3-5 year EuroMTS Covered Bond Aggregate and New EU Government Bond Aggregate.
First, we applied the multi-factor model for the benchmark, in this case the EONIA, to measure both the interest rate risk and the credit risk. For each of these risks, we obtained an X-ray or map of the risk factors, which can be compared to that of the MMF at any given moment.
For the rate risk, on 30 September 2008, only one-third of the MMF analysed demonstrated an almost non-existent rate risk, while half showed a risk which we could describe as slight. Finally, two money market funds presented a marked interest rate risk. In actual fact, they turned out to be the least valid funds... and the best-performing ones!
In terms of credit risk, half of the funds analysed presented no such risk on that date, while five of them revealed certain trends in relation to the EONIA and a strong risk.
Lastly, we conducted a study consisting of a dynamic analysis of three funds in order to test the model’s forecasting ability and the persistence of the risk factors. To do this, we selected a fund which had suffered a credit incident in September, and another which showed no particular risk on 30 September, and a third which had successfully passed the first two tests. We then measured the credit risk factors from the EONIA, which we compared to each of the funds at the start of each month (i.e. 9 comparisons), from the start of January to the start of September 2008.
For the first fund, we noted that most of the measurements revealed high risks during the months preceding the fall in market value. In other words, the incident, in this case, was foreseeable.
In the case of the second fund, we noted that in seven cases out of nine, there was a high credit risk, although it was low on 30 September.
Finally, for the third fund, we observed regular and stable behaviour with no relative risk in relation to the EONIA.
With money market funds, as with the other types of fund, there is a general, well-respected rule: in the long term the manager cannot over-perform on his reference index without taking more risks than those with neutral exposure. As far as MMF are concerned, we saw that on most occasions, the risk run was not usually an interest rate risk, but a credit risk. The manager essentially tries to obtain a positive spread in relation to the EONIA, which he finds all the more easily if he sacrifices debtor quality. In extreme market conditions such as those we are currently experiencing, the risk of suffering a credit incident as a result of such a strategy is not a negligible one.
A second conclusion we were able to draw is that rating, regardless of who performs it, and/or classification is no guarantee of security at this level.
Our final conclusion relates to the fact that we were able to detect a certain degree of stability or recurrence in risk-taking.
In any case, for any investment in MMFs, reliance on a multi-factor model now seems to offer the best security in terms of understanding relative risk.
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