Published: September 01, 2012
Critics of MMFs have argued that MMFs would be less ‘bank-like’ (i.e., not shadow banks) insofar as constant net asset value (CNAV) MMFs converted into variable net asset value (VNAV) MMFs. But what is a CNAV MMF? What are the supposed risks posed by CNAV funds? And should CNAV funds be required to adopt a VNAV?
Like any other investment fund, the share price of an MMF is calculated by dividing its net asset value by the number of shares in issue: therefore increases or decreases in the net asset value of the fund, will cause increases or decreases in its share price. The precise relationship between the net asset value and the share price of a fund is determined by the degrees of significance to which its shares are priced. This is best illustrated by way of example.
Assume at T1 a newly formed MMF issues 100m shares upon receipt of an initial subscription of EUR100m, and invests the subscription in a diversified portfolio of short-term, high quality money market instruments. Assume the net asset value (NAV, i.e., the mark-to-market value of the fund’s assets and liabilities) of the fund changes over time as shown in Table 1. Assume the fund receives no further subscriptions or redemptions during that period, and ignore income and expenses. Then depending on whether the fund prices its shares to six, four or two decimal places, and assuming they round to the nearest number, then the price per share would increase/decrease as shown in table 1.
CNAV funds price their shares to two decimal places – a practice know as ‘penny rounding’. As can be seen from that example, penny rounded shares are sensitive to movements in the funds’ NAV of 0.5% (or 50bps). Because it is rare for the NAV of a MMF to move by as much as 50bps, the share price of a CNAV fund tends to remain constant, hence the description of the fund as tending to have a ‘constant’ NAV. CNAV funds that fail to maintain a constant price are described as having ‘broken the buck’, as occurs at T5. In the past 40 years, this has only occurred twice, and because of a credit event in the CNAV fund’s portfolio.
VNAV funds price their shares to more than two decimal places, and for that reason are more sensitive to movements in the funds’ NAV. As can be seen from the example, each additional decimal place causes a ten-fold increase in the sensitivity of the share price to changes in the NAV. This increased sensitivity means that the share price of a VNAV fund tends, other things being equal, to be more variable than a CNAV fund.
Other factors also impact the variability of the share price of a MMF, including the basis on which assets are valued (mark-to-market accounting versus amortised cost accounting) and whether the fund accumulates or distributes its net investment income. However, for the purposes of this article, the key difference is that CNAV funds ‘penny round’ their share price to two decimal places, whereas VNAV funds round their shares to more than two decimal places.
CNAV funds have existed for about 40 years, without much incident or comment from regulators. However, following the events of 2008, some regulators have argued that CNAV funds are inherently prone to large redemptions because they provide investors with a ‘first redeemer advantage’. By contrast, those same regulators have argued that daily fluctuations in the price of VNAV funds desensitise investors to losses and therefore make them less prone to redeem in a financial crisis. For example, the President’s Working Group has said:
“By making gains and losses a regular occurrence, as they are in other mutual funds, a floating NAV could alter investor expectations and make clear that MMFs are not risk-free vehicles. Thus, investors might become more accustomed to and tolerant of NAV fluctuations and less prone to sudden, destabilizing reactions in the face of even modest losses.”
In principle, the price of a VNAV fund would decline during a financial crisis. Investors usually respond to declining prices/increasing losses by selling assets, especially if those losses arise in a fund whose investment objective is to provide security of capital, and even more especially during a financial crisis, which would tend to heighten their loss aversion. Is there any evidence that daily fluctuations in the price of a VNAV fund have changed these deep seated behavioural norms, and that VNAV funds are less susceptible to redemptions?
French MMFs (monétaire funds) are VNAV, and suffered very few redemptions in 2008. However, French enhanced MMFs (dynamique funds) are also VNAV, and suffered very significant redemptions in 2007 (indeed, more significant than US CNAV MMFs suffered in 2008). By contrast, IMMFA MMFs are CNAV and suffered relatively few redemptions in either 2007 or 2008.
It is hard, therefore, to establish any clear correlation between the pricing policy of an MMF and whether or not it experienced redemptions in 2007 or 2008.
Investor surveys have consistently indicated that mandating a move from CNAV to VNAV would result in very significant outflows from MMFs. For example, a recent survey of US corporate treasurers by Treasury Strategies, Inc. indicated that if US MMF were mandated to adopt a variable NAV, then:
Investors domiciled in any country which taxes income differently from capital gains (such as the USA) would face an additional compliance burden, in having to calculate the small gains or losses that may have arisen between the dates of subscription and redemption in a VNAV fund. (It is no accident that investors domiciled in countries which tax income and gains differently tend to buy distributing shares in CNAV funds, and investors domiciled in countries which do not distinguish between income and gains for taxation purposes tend to buy accumulating shares, and may be indifferent between VNAV and CNAV funds to the extent that the daily accumulation of income is usually greater than the daily variability in price in the VNAV fund.)
Also, the variability in the price of a VNAV fund would complicate cash-flow planning for institutional investors.
Given the importance of CNAV pricing to investors, it is hard to justify requiring CNAV funds to adopt a variable NAV, unless VNAV funds can be clearly be show to be less susceptible to redemptions that CNAV funds.
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