Money Market Fund Industry Awaits Reform
The financial crisis has stimulated dramatic changes across many facets of the securities markets in the past year, and the money market fund industry is no exception. This once-sleepy sector of the market was rattled by previously unimaginable spread widening and liquidity strains, culminating with the Reserve Primary Fund, a $64.8 billion money market mutual fund, “breaking the buck” in the wake of the Lehman Brothers bankruptcy last fall (meaning its net asset value fell below $1 per share). Despite the volatility, money market funds have otherwise proved to be generally resilient, with U.S. money market fund cash balances rising well above the 5-year average balance of $2.6 trillion to $3.5 trillion in 2009. Nevertheless, increasing concern regarding the safety of these funds during extreme market conditions has precipitated regulatory action within the asset class.
The government support programs implemented to stabilize the short-term markets have so far proved to be largely successful, but as markets continue to heal, some of these programs are beginning to expire. The Temporary Guarantee Program for Money Market Funds, which provided fund companies with temporary $1 net asset value insurance to prevent another Reserve Primary Fund–type event, expired in September. According to Treasury Secretary Geithner, the program had served its intended purpose of bringing stability to the industry “during the market disruptions last fall.” Indeed, such programs have helped the short-term market regain its footing, but long-term changes still loom on the horizon for money market funds.
In December, the President’s Working Group on Financial Markets (PWG) will propose changes to rule 2a–7, which governs the ubiquitous $3.5 trillion money market fund industry. These changes are expected to include restrictions on certain investments, a reduction in the average maturity of underlying securities, additional gating flexibility to mitigate “run-on-the-fund” risks, and new stipulations concerning fund liquidity profiles. The upcoming changes will not only alter the structure and improve the safety of money market funds, but they will also impact money market fund performance. Under the new regime, money market fund yields will more closely track the federal funds rate because alpha-generating strategies, such as overweighting floating rate notes and maintaining longer durations, will be constrained.
Meanwhile, the number of commercial paper issuers has decreased as a result of the economic downturn, and banking institutions with alternative funding mechanisms are less inclined to borrow. While this has led to a dramatic improvement in liquidity, it has also resulted in historically low money market yields—and investors have been keen to search for alternative cash solutions in response. Consequently, customizable separate accounts have increased in popularity. Separate accounts offer several benefits, including flexible investment guidelines, customized reports, enhanced liquidity management, and the elimination of shareholder concentration risks. Accordingly, these vehicles could potentially add between 15 and 50 basis points in excess return over a typical money market fund through greater investment guideline flexibility and lower fees (we estimate the average separate account fee for a money market fund to be between 12 and 15 basis points, compared to an average of 20 basis points for the institutional share class of a typical money market fund).
In the aftermath of the financial crisis, capital preservation and liquidity are at the forefront for money market investors. Financial markets have become more sophisticated, and when tested in 2008, rule 2a–7 parameters have proved to be antiquated. We believe that eliminating the rule’s nebulous characteristics will make money market funds more secure and that implementing more stringent investment guidelines will have a positive impact on the industry. Forthcoming changes and historically low yields will undoubtedly prompt market participants to take another look at how they manage their short-term assets. Returning to more conventional means of short-term asset management, however, should improve money market investors’ ability to achieve their capital preservation and liquidity objectives. Moreover, customizable separate account vehicles offer investors an opportunity to add value to their short-term investments, notwithstanding the aforementioned challenges. We continue to monitor this closely, and will keep you apprised of new developments in the money market sector as the PWG finalizes its plans in December.
- Money Market Fund Industry Awaits Reform
- Fixed Income Sector Review
- Economic Update
- International Bond Market Update
- Investment Performance
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