Published: December 01, 2008
The recent market turmoil, the origin of which can be traced back to the US sub-prime mortgage market, has created new challenges for clients with large cash balances to manage. As investment funds and banks around the world have been impacted, investors are becoming increasingly cautious regarding where and how their cash is invested.
Investors in Europe have reacted swiftly to the onset of this liquidity crunch, seeking safer homes for their cash investments. Assets perceived as likely to provide a greater level of protection from the contagion have enjoyed greater demand.
The need to diversify risk within cash investments has emerged as a clear theme and has become a more significant driver of investors’ decisions. The underlying motivation is the realisation that the path of contagion has been difficult to predict. In other words, it has been difficult to foresee which assets or individual issuers could be hit next by a crisis of confidence.
As even the top-tier of the global banking sector has fallen victim to the decline in market liquidity and confidence, investors’ appetite for risk in their cash investments has moved firmly into conservative territory. Where investors had previously sought a greater yield, their focus shifted dramatically during 2007 to investing in lower-risk and more stable assets.
As a result, AAA rated money market funds, have seen a significant increase in assets under management in 2007 and 2008. This growth has been underpinned by a key characteristic of these money market funds, namely their ability to maintain stable net asset values before and, more importantly, during periods of extreme market volatility.
Maintaining a stable net asset value ensures that the capital invested in the fund is preserved and this remains the central factor motivating an investor’s decision to use this type of liquidity fund as the home for their capital.
AAA rated money market funds are mutual funds that invest in a range of high quality money market instruments including overnight deposits, commercial paper, certificates of deposit, fixed and floating rate instruments.
They provide the benefits of pooled investment, as investors can participate in a more diverse and high-quality portfolio than they otherwise could individually. AAA rated money market funds are actively managed within rigid and transparent guidelines to offer safety of principal, liquidity and competitive sector-related returns. [[[PAGE]]]
There are two basic types of AAA rated money market funds available: constant net asset value (CNAV) and accumulating net asset value (ANAV). Shares in CNAV money market funds are issued with an unchanging face value (such as €1 per share). Income in the fund is accrued and can either be paid out to the investor or used to purchase more shares in the fund at the end of the month. ANAV funds, known alternatively as ‘roll-up’ funds, operate under the same investment guidelines as constant NAV funds and income is accrued daily. However, unlike CNAV funds, income is not distributed but reflected by an increase in the value of the fund shares.
The principal providers of AAA rated money market funds in Europe have formed a trade association, the International Money Market Fund Association (IMMFA). IMMFA members adopted a Code of Practice in February 2003 that aims to ensure that members offer a high quality product and service to investors. All IMMFA funds are triple-A rated by one or more of the rating agencies (Standard & Poor’s, Moody’s or Fitch). Further details can be obtained at www.IMMFA.org.
The rating criteria broadly comprise four main areas of analysis that address a fund’s operating principles: its credit quality, portfolio construction, fund management and regular post-rating inspection. These are described in more detail below.
Credit quality is evaluated on three levels: what the fund can buy, who it can do business with (including the exact nature of business) and who it can appoint to keep its assets safe. The rating criteria therefore stipulate the fund’s asset range and restrictions (such as quality, type and currency), acceptable counterparty risk (for all transaction based investments) and acceptable choice of custodian. [[[PAGE]]]
The most complex part of analysing a money market fund is judging a fund’s sensitivity to changing market conditions and, therefore, gauging a measure of its ability to shield investors from adverse market swings. All money market securities (rated or otherwise) are subject to price fluctuations – based on interest rate movements, maturity, liquidity and the supply and demand for each type of security. Quantifying the cumulative effect of these is crucial to assessing overall portfolio performance.
The rating process requires an assessment of a fund manager’s operations. Key areas of interest are the fund manager’s level of experience, the stated investment objectives, portfolio management techniques, risk aversion strategies, operating procedures and internal controls, including disaster recovery. Owing to the precision necessary in running a money market fund successfully, every aspect of the fund’s management must be able to withstand close scrutiny and demonstrate effective, ongoing integrity of operation.
Owing to the constraints of the rating criteria, rated money market funds are contractually obliged to supply all portfolios for periodic rating agency inspection: fund surveillance, as it is called. Any infringement or potential concern is communicated to the fund and timely rectification is required.
Focus on fund strategyWhile investors have sought greater levels of security, the turmoil in markets has also been clearly reflected in the positioning of money market funds. The most obvious theme at a fund level has been a shift by managers of money market funds to a more conservative stance and increased levels of overnight liquidity.
As an example, across the IMMFA members’ range of funds, overnight liquidity has risen from an average level of 10% pre liquidity crunch to approximately 30% today. Having the infrastructure to enable the adjustment of a fund’s allocations in a pragmatic and risk-controlled manner is a critical feature that investment managers must be able to demonstrate. The recent market conditions have served to highlight these capabilities.
To this end, larger and more established managers of money market funds will typically have a dedicated credit resource, focused purely on cash investments. This team is responsible for approving, declining and providing ongoing due diligence and monitoring of individual issuers. Indeed, the IMMFA Code of Practice states that a manager should perform its own credit risk due diligence and should not rely solely on credit ratings.
Having well resourced portfolio management, credit analysis, research and client service teams has become increasingly important and valued by investors. This is to ensure a robust investment process is followed and clients are provided with a high-quality service pre and post investment in a money market fund.
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Driven by recent risk aversion, some investors in Europe have sought to manage their cash by investing in government-issued securities. Observing this shift, investment managers have developed a new method to gain exposure to government risk, based on the proven mechanism of the AAA-rated liquidity fund strategy outlined above. Liquidity funds have been launched in Europe in recent months that invest their portfolio solely in government-issued debt and securities collateralised by government debt. With a focus on conservative innovation, investment managers of these government liquidity funds have seen a large inflow in assets from European clients seeking a low-risk investment strategy that still provides the liquidity key to managing cash effectively.
The turmoil in the credit markets has also provided the opportunity for investors and their investment managers to develop a closer way of working together. Previously, asset managers’ skill in portfolio management was judged by the consistency of performance and fund growth over time. As the credit crunch has unfolded, investors have become more interested in the underlying holdings of funds and investment processes that their managers employ.
Recognising these themes, there has been an increase in the level of proactive engagement with clients by fund providers. This has led to a greater level of transparency and fostering open dialogue with clients. A key element of this has been to provide more detail around a provider’s credit due diligence processes, thus building a wider appreciation of the investment philosophy and encouraging additional confidence.
During these times of market uncertainty and volatility, it is clear that adopting a conservative approach to cash management is vital. Investors have shifted their focus firmly to capital preservation and provision of liquidity when investing in money market funds. We believe that, in working closely and openly with their investment managers, investors can achieve a safer and more successful cash management strategy and investment managers can remain responsive and aligned to clients’ evolving needs.
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