Published: August 01, 2009
Money market funds globally amount to over USD 5tr of investment, and include both retail and institutional investment. They are now utilised to such an extent in certain markets that they are an accepted element of the monetary system. They have experienced almost continuous growth since inception nearly 40 years ago. This period has included a number of economic downturns and financial market volatility and adversity, none of which had any adverse impact on money market funds. And whilst the recent financial crisis has impacted these funds, it is notable that, when the first break the buck event occurred in 1994 there was no noticeable impact on the product or financial markets more generally.
In light of the market turmoil which has been experienced, the objectives of a money market fund are arguably the priorities which many investors seek more than anything; capital security and liquidity.
Whilst it is prudent to continually enquire whether an investment remains viable and robust, the reasons why we now ask that of money market funds must be contextualised. The events which started with the bankruptcy of Lehman Brothers on September 14 2008 resulted in the worst financial crisis since the 1930s. That only one money market fund should record a loss during this recent crisis should be seen as testament to the strength of the industry (there are approximately 2,000 money market funds currently which seek to maintain a constant net asset value).
The benefits of the product, and the reason why investment should be considered, remain as true now as two years ago before the credit crunch had even begun to materialise. Indeed, in light of the market turmoil which has been experienced, the objectives of a money market fund are arguably the priorities which many investors seek more than anything; capital security and liquidity.
Money market funds are designed with these two objectives in mind; they are not however risk free. The experience of investors in The Reserve Primary Fund is testimony to this. The product literature for a money market fund stipulates that capital security and liquidity are objectives and may not be achieved. Further, the value of an investment can fall as well as rise and is not guaranteed. Investors should therefore satisfy themselves that they are comfortable with the risk inherent in the product, both initially and on an on-going basis.
It is important to put that risk into context. In the almost 40 year history of money market funds, there have only been two instances in which investors have lost money. And of those two instances, one relates to a 4 cent loss in the dollar, and the other to a 3 cent loss. This is immaterial when compared to the loss which could arise should an investor have direct exposure to an insolvent bank or other counterparty. Using Lehman Brothers as an example, investors in credit default swaps issued by Lehman will lose 91.375 cents in the dollar. The losses which investors have experienced in the two money market funds that have broken the buck are hardly comparable.
Whilst this risk exists, a money market fund is designed to mitigate it to the best extent possible. The intention then is to allow an investor to receive his investment intact when requested. The fund manager attempts to achieve this through prudent investment management and extensive credit research, independent of any credit rating. Consequently, the money market fund will only invest in those assets which have been independently assessed as high quality.[[[PAGE]]]
A money market fund will provide an investor with a number of benefits, the most fundamental being that any investment in a money market fund represents a diversified risk. The fund receives investment from a large number of investors. This investment is pooled and used to purchase a variety of underlying assets. Each investor in the fund is entitled to a proportion of the underlying assets which represents the size of his holding relative to the total size of the fund. In this way, the risk associated with any individual asset within the portfolio is spread across all investors; the greater the number of investors, the greater the reduction of risk.
A money market fund will provide an investor with a number of benefits, the most fundamental being that any investment in a money market fund represents a diversified risk.
If one of the underlying assets within the portfolio then loses value or defaults, that risk is spread, limiting its impact on the total portfolio.
Investment in a money market fund is thus beneficial when compared to any direct investment with either a bank or in a specific money market instrument. With direct investment, the investor is exposed to any loss experienced by the counterparty.
The fund is also a separate legal entity, distinct from the fund manager or sponsor. It has its own board of directors, who have a responsibility to act in the interests of the shareholders, i.e. the investors in the fund. The appointment of a fund manager is subject to a contract for services. In the event of any adversity faced by the manager or sponsor, the assets of the money market fund would be segregated with no risk of loss to the underlying clients. The investment management mandate may pass to another manager with no impact on the clients other than the administrative burden of having that mandate passed to another manager.
The investor can therefore be satisfied that the only risk associated with his investment relates to the risk within the portfolio of assets. The diversification within the portfolio and across the investor base will then reduce the impact of that risk upon an individual’s investment.
Money market funds are also designed to provide liquidity, allowing the investor to have immediate access to his investment with no penalty applied upon withdrawal. The fund manager should attempt to understand the needs of his investor base and will enquire about the likely redemption activity and needs of an investor before accepting the investment. The fund manager will then construct a portfolio which reflects the impending liquidity needs of the investors and which reflects the underlying liquidity available in the market place. The fund manager will also perform stress testing to determine the impact of a variety of scenarios on the fund, and how this should be mitigated. This allows the manager to prepare for stressed circumstances and to facilitate the provision of liquidity to investors in those situations. Based upon these outcomes and the risk appetite of the fund manager and the directors of the fund, the fund will hold liquidity over and above the known requirements in order to provide a contingency buffer from which unanticipated redemption requests can be facilitated.
In addition to the capital security and liquidity, a money market fund offers investors other key benefits. A money market fund provides a means through which cash management may be outsourced to another entity. The money market fund manager will employ full time credit analysts who are able to achieve a level of due diligence which not all investors can match. Investors are therefore able to benefit from the professional money management skills which the money market fund can provide. These funds will also provide economies of scale given their size, which many investors will not be able to compete with. This professional cash management can be obtained for a fee which is small when compared to the likely cost of in-house provision. Further, the range and breadth of instruments and maturities in which a money market fund will then invest will likely be more extensive than can be achieved by most investors. The nature of a fund will also allow investors to benefit from longer duration yields without having to be in the market for an extended period of time.[[[PAGE]]]
To ensure that the product is able to continue delivering against the objectives of capital security and liquidity, a money market fund is subject to a number of requirements which are designed to limit the risk to which the fund is exposed. The money market funds represented by the Institutional Money Market Funds Association (IMMFA) membership, must all have achieved a triple-A rating, comply with the IMMFA Code of Practice and be authorised under the UCITS directive. This combination implements a set of investment parameters within which the funds must operate.
The money market fund manager will employ full time credit analysts who are able to achieve a level of due diligence which not all investors can match.
The funds will be permitted to invest only in high quality instruments, as evidenced by a credit rating, must diversify across issuers with a limit placed on the maximum exposure to a single counterparty, may invest only in short-dated instruments, with limitations both on average and final maturity, and must regularly monitor any variance between the amortised cost and mark-to-market cost of the assets and portfolio.
The monitoring of any variance between these two values must be accompanied by an escalation procedure. At pre-determined thresholds, which commence at a variance of only 10 basis points, the matter will be referred initially to the senior management of the fund management company, and then finally to the directors of the fund. The intention of these escalation procedures is to ensure action is taken in the best interests of the shareholders and could, for example, involve the sale of individual assets. They also act as a means of ensuring that senior management and the fund’s directors are made aware if the net asset value of the fund is under pressure and can act in a manner consistent with the fund’s objectives.
These investment restrictions are actively monitored by both the fund manager and the fund’s administrator to ensure compliance is ongoing. In addition, the rating agencies will require information from the fund in order to determine whether the fund continues to qualify for a triple-A rating; this will necessarily involve the monitoring of some of the investment restrictions.
The combination of the investment restrictions and the monitoring performed to ensure that the fund only operates within those restrictions provides for a very robust product. The amount of flexibility permitted to the fund in terms of what it may invest in and how it is structured and priced is limited, with the intention of those limits being to allow the fund to continue to meet its objectives and minimise the possibility of investor loss.
Cash management has never been so important. The recent market turmoil that has been experienced demonstrates the importance and necessity of prudent cash management. Money market funds have historically provided a means of outsourcing cash management to a professional manager. Despite the recent market turmoil, this remains true today.
A money market fund is designed to provide an investor with capital security and liquidity. These are two objectives that most investors will have, given the current economic crisis and continued uncertainty in financial markets. Whilst a money market fund is not risk free, the investment restrictions placed on the fund and the fundamental benefit of a collective investment scheme, i.e. the diversification of risk achieved through a pooled investment, combine to provide a product where the potential benefits should always outweigh the risks.
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