Published: July 01, 2010
While most mutual funds are managed with the objective of increasing their value and providing shareholders with a return, money market funds are somewhat different. The primary objectives for money market funds are ensuring the security of capital and providing shareholders with access to that capital at all times. A return, or yield, is a secondary consideration.
Although money market funds invest in assets whose value can change over time, the funds’ net asset value (NAV) may remain constant at 1.00. How can fund managers square this circle? The answer lies in the use of amortised accounting.
Amortisation is an accounting technique which diminishes the value of an asset in a gradual manner over time. If this is applied to money market instruments, any discount / surplus initially paid over par (face value) is gradually added to / taken off the value of the instrument over time. Amortisation of money market instruments is conducted on a straight line basis (i.e., in a regular fashion) over the life of the asset, helping to provide continuity in asset values.
The use of amortisation is permitted by fund regulation (Undertakings for Collective Investment in Transferable Securities, or UCITS) as well as international accounting standards (International Financial Reporting Standards, or IFRS). Under IFRS, assets should be booked at fair value. Where assets are ‘held to maturity investments’, fair value should be measured using amortised cost under IFRS standards. As money market funds emphasise security and liquidity, the fund manager does not actively look to sell assets in the secondary market to generate profit (or realise a loss). This is because liquidity in secondary markets can rapidly disappear, as we recently witnessed. [[[PAGE]]]
Since fund managers generally do not sell assets in the secondary market, money market funds always attempt to have enough assets maturing (natural liquidity) to meet redemptions. Therefore, fund managers intend to hold all assets until they mature, and will structure the maturity profile of their fund to reflect the likely liquidity needs of their investors. Since fund managers of constant value money market funds will effectively only purchase ‘held to maturity investments’, the fair value of these assets will be their amortised value.
Investors should regularly monitor the fund's exposure to credit, interest rate and liquidity risk.
Given the objectives and management strategy of money market funds, amortisation remains an appropriate valuation method. However, the market value of these assets – or the price at which they can be sold, provided that there is a secondary market – may still fluctuate. So, what does this imply for the funds?
The market value of an asset is the price that could be obtained if that asset were sold at a given point in time in the secondary markets. Multiple factors may impact the market value of a money market instrument, including movements in interest rates, credit spreads and the perception of an issuer’s financial strength.
To complicate matters further, some money market instruments are not quoted on public markets. In these instances, investors rely on independent pricing sources (often market makers) to offer a price. If there is no secondary market because market liquidity has disappeared, it can be extremely difficult to obtain a market price. Indeed, the total absence of a credible market for a particular asset type has made it impossible to calculate a market price in the past. In these rare instances, the fair value of money market instruments has been deemed to be the amortised value, even if the assets are not being held to maturity.
Since many factors may influence the market value of an asset, as noted earlier, it is likely that the market and amortised values will differ at a given point in time. Also because the value of a money market fund is the sum of the values of all the assets it holds, there could be a variance between the market and amortised values of a share in a money market fund. The value of a fund calculated using market prices, as opposed to amortised cost, is colloquially known as the shadow NAV.
Whilst amortised and market values of the fund differ (e.g., the fund’s NAV, calculated using amortised values and the shadow NAV), this difference in value should typically not be more than a few basis points. Since money market funds invest in high quality, short-term assets, the likelihood of a material deterioration of these assets is limited.
If the discrepancy between the market and amortised values is typically small, why calculate the market value? Market value reflects the value of a fund’s share if that fund were liquidated at a given point in time. If the discrepancy between the market and amortised values exceeds 0.5% (or 50 basis points), the value of a fund’s share (rounded to two decimal places) would no longer be equal to 1. Under UCITS legislation, in these specific instances the fund is obliged to revert to mark-to-market valuation. This is known as the point when a money market fund ‘breaks the buck’ (i.e., loses its constant NAV of 1). In these rare cases, the NAV, or the value of a share in the fund, falls below 0.9950 or rises above 1.0050. [[[PAGE]]]
To act in the best interests of shareholders, a money market fund manager will monitor any variance between the amortised and market values, both at a fund and asset level. Monitoring is conducted weekly (at least), with the frequency increasing if there is any indication of stress in financial markets. The fund will then operate escalation procedures in any situation where a material discrepancy exists between the amortised and market values. These procedures should ensure that the fund considers any material variance when it arises and that it takes the appropriate actions.
The Institutional Money Market Funds Association’s Code of Practice outlines suggested escalation procedures. At an asset level, the Code suggests that the administrator should inform the fund manager at a variance of 30 basis points. At a variance of 50 basis points, the administrator should notify the fund manager, the fund’s Board of Directors and trustee. At this point, the fund manager should recommend an appropriate course of action to the Directors, who will determine the action to take, which could include selling the asset to limit potential future losses, or holding onto the asset if they believe all of the principal will be repaid at maturity as was originally expected.
At fund level, the Code suggests that the administrator notifies the fund manager if the variance becomes 10 basis points. The fund manager’s senior management should be notified at 20 basis points, and the fund’s Board of Directors and trustee should be informed at 30 basis points. The fund manager should then recommend an appropriate course of action to the Directors.
Ideally, the two escalation procedures would run in tandem to address any discrepancies at either asset or fund level. If and when any material variance arises, and it is deemed appropriate to take action, it should only be taken where in the best interests of the shareholders. With these controls in place, the fund manager can ensure that the 1.00 value of a share in a money market fund is always close to the value which could be generated by selling assets in the secondary markets in a worst-case scenario.
Understanding the valuation methodologies used by a money market fund is beneficial. However, there are other factors which provide more insight into investing in a money market fund. Most importantly, investors should regularly monitor the fund’s exposure to credit, interest rate and liquidity risk.
The fund’s exposure to credit risk and credit process will point to the quality of assets that the fund is purchasing. Exposure to interest rate risk, as shown by the duration, will indicate whether the fund is purchasing very short-term assets. Exposure to liquidity risk will impact how quickly the fund can sell assets in order to meet redemption requests, influencing the ongoing ability to provide same-day liquidity.
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