Published: April 18, 2008
The recent market turmoil has created new challenges for clients with large cash balances to manage. The origin of these events can be traced back to the US sub-prime mortgage market. Since February 2007, the value of securities in this part of the US residential mortgage-backed securities (RMBS) market has declined, in line with a downturn in the performance of the underlying mortgage loans.
Recent events have led to a continued cycle of risk aversion, uncertainty, illiquidity and price volatility across most major asset classes, including traiditional money market securities.
Initially, this issue was contained largely in the US sub-prime mortgage-backed market. However, as hedge funds have been forced to close, banks have taken significant hits to their profits and monoline insurance company credit ratings have come under pressure. These and other problems that markets have faced caused concerns to spread quickly to other sectors.
Investment funds and banks around the world have been impacted and investors are becoming increasingly cautious regarding where and how cash is invested. Banks also became less willing to lend to each other, creating illiquidity in the money markets and threatening the funding on which the banking system depends.
These events have led to a continued cycle of risk aversion, uncertainty, illiquidity and price volatility across most major asset classes, including traditional money market securities.
The major global central banks have been adding liquidity to the market in an effort to normalise short-term interest rates and bring them more in line with their target rates (for example, the Base Rate in the UK). Initially, the central bank intervention was on a stand-alone basis but on two occasions over the past seven months, in December 2007 and March 2008, there has been co-ordinated intervention to add liquidity to the market. This has seen the US Federal Reserve, the European Central Bank, the Bank of England, the Swiss National Bank and others all add liquidity into the market at the same time. This action has had some success but has been on a temporary basis to date.
Investors have reacted swiftly to the onset of this liquidity crunch, seeking safer homes for their investments. Assets perceived as likely to provide a greater level of protection from the contagion effects caused by the fall in confidence in the US sub-prime market have enjoyed greater demand.
The need to diversify risks within cash investments also emerged as a clear theme and has become a more significant driver of investors’ decisions. The underlying motivation for this was the realisation that the path of contagion has been difficult to predict. In other words, there was no way to identify which assets or individual issuers would be hit next by a crisis of confidence. [[[PAGE]]]
As even the top-tier of the investment banking sector fell victim to the decline in market liquidity and confidence, investors’ appetite for risk in their cash investments 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 liquidity funds. As a result, International AAA-rated money market funds, which had already seen rapid growth during 2006, saw a significant increase in their assets under management in 2007.
This growth has been underpinned by a key characteristic of these International money market funds - their ability to maintain stable Net Asset Values (NAVs) before and, more importantly, during periods of extreme market volatility. Maintaining a stable NAV ensures that the capital invested in the fund is preserved. This remains the central factor motivating an investor’s decision to use this type of liquidity fund as the home for their capital, instead of using alternative short-term securities.
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 many managers of stable NAV money market funds to a more conservative stance, as well as increasing their overnight liquidity levels.
Traditional offshore AAA-rated stable NAV funds invest in a range of high quality money market instruments. This set of assets includes overnight deposits, commercial paper, certificates of deposit, fixed and floating rate instruments, and asset backed securities.
Across the Institutional Money Market Fund Association (IMMFA) members’ range of AAA-rated stable NAV funds, the immediate access liquidity bucket has risen from a level of 10% pre liquidity crunch to around 30% today.
Having the infrastructure that enables 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.
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 Code of Practice of IMMFA states that a manager should perform its own credit risk due diligence and should not rely solely on credit ratings. This is also becoming an increasing focus of global regulators as they respond to recent market events. [[[PAGE]]]
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.
Adversity drives closer alliancesThe turmoil in the credit markets has 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.
There is one key positive theme that has come out of the credit crunch. Whatever the approach to weathering the storm, we believe a closer, more open relationship between investment managers and their clients is the basis for more successful and safer cash management.
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