Pedestrian returns doing little to halt investor exodus

Money market funds have struggled to recover from the impact of the credit crisis, suffering net outflows since the start of the year as investors switch back into equity funds, and also heavily into bond funds, which many perceive as a half-way house in terms of risk. Around $130bn (€95bn) has been taken out of money market funds this year, according to EPFR Global Fund Data, which monitors funds sold in most developed markets and offshore domiciles. These outflows come hard on the heels of the bigger shakedown last year as the credit quality of many money market funds came under the microscope. Even funds that avoided the floating rate notes and subprime asset-backed securities still suffered when investors panicked and the market was hit by excessive redemptions. Low yields Top quality credit yields little, however. Money market funds currently yield around 10-12 basis points a year after fees for dollar-denominated funds, 30 basis points for euro funds and 60 basis points for sterling funds. This is unlikely to change in the near future. Most analysts expect interest rates to stay low for the time being, rising in the third or fourth quarter. “The conundrum for money market funds is that they are operating in an environment where it is hard to generate a return because rates are so low, and therefore these funds are primarily seen as defensive structures and liquidity vehicles,” says Johan Jooste, portfolio strategist, Merrill Lynch Wealth Management, Emea. “They suffered mission creep in 2008, and at the height of the credit crisis there were all sorts of sins in these funds as managers tried to generate returns from impaired quality, illiquid and badly structured instruments,” he explains. “While this aspect has now been sorted out, returns are exceedingly pedestrian, with the result that investors view them as somewhere to put cash, as an alternative to low risk deposits, to avoid being unlucky with one big bank. Investors are now intolerant of illiquid and opaque structures, and lots of clients are still skittish about risk.” A growing market However, providers say the overall market has been growing, in preference to the perceived risk of putting money on deposit with the banks. Although bank balance sheets are still being repaired and shrunk wherever possible, a significant number of investors remain extremely nervous about putting money on deposit with a single bank and do not have the economies of scale to diversify. Chris Oulton, CEO, Prime Rate Capital Management, points out that the money market fund space has grown from $1bn to $500bn since 1998, according to the Institutional Money Market Funds Association. “A well managed and liquid portfolio appeals as a good alternative to relying on a few bank deposits as it is very difficult to diversify sufficiently widely, and uncertainty persists about the banking system,” he says. Prime Rate Capital Management took the decision to list on its website all the holdings in its Prime Rate Cash Management UK fund, launched March 2008, with full details of the assets such as days to maturity, and Mr Oulton says that even if clients don’t use this facility, its existence is a comfort. Last year, the most conservative funds gained market share as the strategies of their peers were laid bare. For example, the ING Liquid fund was €1.6bn in the first half of 2009 but had grown to €3.8bn by the end of the year. “It is very conservative with 70 per cent in A1 plus securities – pure short-term with an average maturity below 60 days,” says Vincent Juvyns, client portfolio manager at ING Investment Management. “A fluctuating NAV means that the fund can, in theory, have a negative daily yield, but the positive aspects, more transparency and mark to market valuation, can be seen in the credit crisis.” Similarly, the HSBC Global Liquidity fund, has grown from E6bn last year to €12bn on the back of interest from corporate Treasuries, according to Regional CIO, Olivier Gayno. “At one stage Treasury departments were more confident with having deposits with a couple of banks, but now they think it is better to diversify more broadly, and entering into deposits with 50 banks is clearly impracticable. The fund attracts investors who are looking for more security than the average money market fund. Before management fees, it pays 45 basis points, compared with a peer group that averages around 50 basis points, or 47 basis points on the larger funds, and this is considered a small margin for the greater security.” Differentiation between funds with pure money market strategies is therefore marginal. BlackRock managing director and fixed income portfolio manager Stuart Niman claims a USP in holding 20 per cent in overnight instruments in the Blackrock Euro Liquidity fund compared with an industry norm of perhaps 5 per cent. Pre-Lehman that figure might have been 30 per cent. Buying up debt The fund was also quick to buy supranational debt, which is issued by central governments collaborating to promote economic development, such as paper issued by the European Investment Bank, and also industry debt such as Nedwater. These instruments are highly liquid in a crisis, Mr Niman says, and are generally more focused upon by their issuers than corporate bonds because corporate managements often care more about what they are doing in the business. Currently the fund holds no Greek name, nor Irish name, although they do hold top corporate names such as Santander in Spain, and BNP Paribas and Société Générale in France. Difficulties in Greece have scarcely impacted these funds as its debt is too lowly rated to be included. Mr Niman points out that the potential for Greece and other sovereign state to be downgraded is no surprise because they have deficits that are hard to reduce and Europe’s fixed exchange rate means that their currencies cannot fall, to reduce the value of external debt. But sterling’s facility to fluctuate has implications for inflation and the latest inflation numbers out of Europe suggest underlying inflation is less than 1 per cent for the eurozone compared with over 3 per cent for the UK. New opportunities As the cost of placing new debt rises inexorably in Greece, some analysts working in other areas of the fixed interest arena believe that the risk of sovereign default has been overplayed and there may be valuation opportunities. Several fund managers say they may increase their exposure to Poland, Italy, Ireland and Spain, whom they refer to with the obvious unfortunate acronym. In the past, investors have displayed short memories, quickly reverting to bad habits, but the credit crisis was so severe that risk aversion remains high and the redemptions from money market funds are largely being diverted into bond funds rather than equity funds. Research by US asset manager Vanguard suggests that when markets recovered in the 2003 rebound, investors abandoned money market funds and put their cash back into equity and bond funds in a ratio of 3:1. In stark contrast, at the end of last year, the switch from money market funds was re-allocated to equity and bond funds in a ratio of 1:34. The consensus on corporate bonds is bearish, however. “After the Lehman failure and the government intervention, spreads were very wide and it was a good opportunity to invest part of the portfolio into corporate bonds and this gave us a good return in 2009, but we do not believe there is great value in corporate bonds now,” says Luigi Fallanca, fund manager at Eurizon Capital. “We’re currently prudent in asset allocation and also at country level, but may try to exploit the market in terms of relative value and may start to increase positions in corporate bonds in the second half of the year.”

Crowded playing field brings cost to the forefront “There are a vast quantity of US money market funds and in days gone by the market did what it could to juice up returns, but if you push up rates, you will of course push up risk,” says Johan Jooste, porfolio strategist, Merrill Lynch Wealth Management, EMEA. “Investors now say cash is cash and where they want return they will take it explicitly in say the credit markets, and it will sit in that part of the portfolio,” he explains. “The style of many vehicles has become more homogenous and the universe of acceptable funds is very generic, so the amount of value one can achieve by careful selection is relatively limited,” adds Mr Jooste. Cost is therefore an important selection focus. There are instances, such as in March 2009, where treasury bond rates went to zero for three month paper. For dollar denominated funds, that would imply a negative yield after fees, but in the event some managers waived fees for a month or two rather than suffer redemptions. Investors have also started to ask for segregated accounts, virtually unheard of in Europe until recently. Partly, this is a response to the tighter investment guidelines drawn up in the wake of the financial crisis, particularly guidelines introduced in December by Europe’s Institutional Money Market Funds Association that oblige triple-A rated funds to hold at least 5 per cent of their assets in overnight securities and 20 per cent in securities maturing within one week to ensure redemption requests can always be met. These restrictions will further impair returns. But not all investors need such high levels of liquidity, and feel they are paying to eliminate a risk when they do not need to. While a money market fund is the right place for cash required at short notice, a customised segregated account with a longer duration can earn a higher return while still addressing the investor’s needs, particularly in the corporate treasurer market.

Chris Oulton, Prime Rate Capital Management