Filling the Gaps: Money Market Funds

by Mark Allen, Head of EMEA Cash Sales, Goldman Sachs Asset Management

A year since the collapse of Lehman Brothers, with all that has happened since, there is still speculation about the reasons behind the crisis and the potential solutions and ways in which the financial markets need to change to avoid a similar crisis in the future. These issues are complex and may take years to fully understand and resolve; what is apparent, however, is how corporate perceptions of liquidity and risk have been transformed. Eighteen months ago, the majority of treasurers were satisfied with using short-term deposits for their short-term liquidity requirements. Today, with a far greater awareness of liquidity and counterparty risk, we see that treasurers are seeking more secure, diversified and liquid investments for their short-term cash flow. Money market funds (MMFs), specifically AAA-rated IMMFA (Institutional Money Market Funds Association) funds, are suited to addressing corporates’ liquidity and risk concerns, but in order that treasurers can be fully confident in what they are investing, there needs to be complete clarity and transparency over what a MMF comprises and its implications.

The nature of MMFs

Although the use of MMFs was already prevalent amongst corporate investors, particularly in the United States and United Kingdom, the crisis has proved a catalyst for investors of all types to select MMFs. There are a variety of reasons for this. When seeking potential investments, investors consider security, liquidity and yield. These three priorities will differ depending on how immediately a company needs to access this cash. For example, when investing short-term cash required for working capital purposes, security and liquidity will be the most important considerations. For cash that is not required immediately, yield may be a higher priority.

During the crisis, most MMFs have evidenced that they satisfy investors’ needs in these areas more successfully than equivalent investment choices such as bank deposits, as follows:

Security
When investing in a deposit, there is 100% exposure to the counterparty so many investors have selected overnight or short-term deposits, adding to the administration workload. To address this, some investors split their cash into smaller principal amounts to invest with multiple counterparties, again adding to the amount of administration required, and yet they may still maintain a large exposure to each counterparty.

MMFs are inherently diversified as they have a broad asset base with a limit on the proportion of the fund in each asset. This mitigates counterparty risk far more effectively than investing cash across a variety of counterparties and avoids the administration required to achieve effective diversification. In addition, MMF assets are held separately from those of the fund manager, avoiding counterparty risk to the fund manager.

Liquidity
The crisis has emphasised to all market players that cash is only of value if it can be accessed when required. To preserve liquidity, many investors moved their cash into shorter-term, highly liquid instruments during the period when market volatility was at its highest. Today, as conditions return to normal, investors are again dividing their cash buckets into tranches for short-, medium- and long-term investment, but the perception of liquidity risk has changed fundamentally. By providing same-day access to liquidity, MMFs have proved adept at helping treasurers manage liquidity risk. In addition, as new regulations may stipulate limits on the proportion of similar investors in each fund (e.g., by industry segment) the risk of a rush on liquidity is also reduced.

Yield
Yield became the lowest priority of the three cornerstones of cash investment during the crisis. One new class of MMFs which emerged during the crisis was that of MMFs investing exclusively or primarily in short-term government debt. These provide the optimal levels of security and liquidity, but yield is of lesser significance. Today, although these government MMFs will continue to be attractive to some investors, more investors are moving back to traditional MMFs that remain AAA-rated but have a more diversified asset base and can therefore offer a more competitive yield. Indeed, a number of investors make the decision to invest in MMFs on the basis of achieving returns that can be highly competitive compared with deposits.[[[PAGE]]]

The crisis emphasised that MMFs cannot be seen as commoditised products, and significant differences frequently exist between different funds in terms of investment process, asset selection and allocation, and appetite for risk, even within the guidelines for MMFs that exist today. Corporate treasurers are therefore seeking greater transparency from their fund managers to ensure that they are in a position to choose funds that meet their investment approach and attitude to risk. This is not always easy when a variety of different fund types are named or misnamed as MMFs. Consequently, although stable NAV MMFs, both in Europe and in the United States, already adhere to strict investment guidelines, the industry has recently proposed a series of recommendations that aim to strengthen the resilience of MMFs in a crisis, and to ensure fair treatment of investors. In Europe, EFAMA (European Fund and Asset Management Association) and IMMFA have put together a combined proposal to outline a pan-European definition of money market funds and stipulate specific details on their operation. Under the proposal, MMFs will be designated as either ‘short-term’ MMFs or ‘regular’ MMFs, with the characteristics outlined in Figure 1. By using common definitions and criteria for different types of MMFs, it will be easier for investors to make informed investment choices.

In the United States, the report produced by the Money Market Working Group to the Investment Company Institute in the United States argues for the implementation of regulatory and operational reforms intended to make MMFs even safer for investors. These are outlined more fully in the article by Hugh Briscoe of Goldman Sachs Asset Management that appeared in the TMI International Cash Management Guide 2009.

We believe that these changes are positive as they provide investors with greater transparency and control over their investment decisions, whilst retaining the benefits of an outsourced approach to investment management. Although the proposals have not yet been adopted formally, Goldman Sachs Asset Management already has an investment process that is consistent with the EFAMA/IMMFA recommendations. Investors can therefore benefit today from greater certainty and visibility in their fund choices.

MMFs have historically proved a reliable and convenient means for investors to achieve their security, liquidity and yield demands, whilst eliminating the administration burden and allowing investors to take advantage of credit analysis and transaction management capabilities that few would be in a position to implement themselves. Increased regulation will provide greater confidence and clarity to investors, which in turn will encourage the further development of the industry as more investors recognise the value that MMFs bring, whatever the market conditions.