The evolution of money market funds

How has the concept of money market funds evolved over the past couple of years and how has the inclusion of ‘rogue’ assets such as mortgage-backed securities within cash funds damaged their image? The concept of money market funds continues to evolve in Europe. One thing to note is that the term ‘money market funds’ can mean several very different things in the pan European landscape – from the most conservative, stable value IMMFA (Institutional Money Market Funds Association) funds that are the cousins to the US industry right up to all types of “cash plus” funds that may have lost value and therefore lost cash for their investors in the stressed markets of 2007 to 2009. JPMorgan focuses mainly on the stable value space and I will limit my comments to that industry as it’s the one that I am most familiar with. Versus the rest of the pan European industry, I would say that IMMFA funds performed extremely well during the financial crisis, as no investors in IMMFA funds lost money. IMMFA funds also experienced dramatic net inflows over that same time period, so clearly the public favoured the most conservative funds in Europe over the longer dated or higher risk variety of cash funds. Between 2007 and 2009, the IMMFA industry took in $131bn (€96bn) in assets and JPMorgan accounted for $72bn of those flows^*. The good news on the European front is that CESR, the pan European regulator, has taken a real interest in the classification of money market funds in Europe, issuing a consultation paper late last year. CESR has proposed a two-tiered approach to money market funds and risk in Europe and could allow “short-term funds” (most similar to IMMFA funds) to coexist with “long-term funds” or money market funds that take on longer duration or interest rate risk and possibly credit risk. What do money market funds typically invest in? IMMFA money market funds typically invest in the highest rated, short dated money market instruments. These may include overnight bank deposits, term bank deposits and bank certificates of deposits, floating rate notes, commercial paper, asset backed commercial paper, tail end bonds and repurchase agreements. Different managers will have varying degrees of resources on the credit analysis side as well as on the risk management side. Investors should ask questions when they see their manager investing in more complex securities such as asset backed commercial paper to ensure that they are comfortable with the resources and controls that the manager has in place to correctly evaluate complex instruments. Managers should no longer just accept an agency rating, but should be doing in-house credit work on all securities in their portfolios. How has Lehman’s collapse affected the screening and due diligence of underlying investments in money market funds? The Lehman collapse may have been a wake-up call for some managers, but at JPMorgan, we had a very robust credit team, risk management process and stringent internal guidelines that pre-dated the crisis. These processes proved extremely valuable in helping us to navigate the fallout of Lehman as well as the ensuing volatility in short term credit markets in the fourth quarter of 2008. As a result, our screening and due diligence has not materially changed. I would say, however, that the level of screening and due diligence by clients or potential clients (ie investors in money market funds) has risen dramatically. Investors are demanding much greater transparency, improved risk metrics and access to senior management. Clients want to understand particular ‘credit stories’ and really dig into our process and internal guidelines. How do you pick the right issuers? Is credit quality the most important selection criterion? There are many criteria that an issuer must meet before gaining approval for potential use in our money market funds. Credit quality is certainly critical; however, there are several factors that must be considered. We look at how an issuer trades in the secondary market, how much of a particular issue we currently own and what the current concentration of that issuer is within a portfolio. 2008/2009 we also saw the emergence of government guarantee programmes for certain issuers, bringing an entire new level of complexity to the process of approving credits. No two guarantee programmes were identical so we needed in-depth analysis around the legal structures themselves in order to make the correct credit call. One of the biggest considerations was drawing the line between the strength of the guarantee – the sovereign’s willingness to pay – and the strength of the sovereign itself – its ability to pay. All sovereigns were more than willing to backstop their banking systems; however, not all had the means to do so. This was a new level of analysis for us at the time. Is there any asset class/underlying, asset-backed securities for instance – that represents a good investment opportunity in the current environment? We do not make sector bets when we invest our money market assets. We only invest in the highest quality paper; however, instruments like asset backed commercial paper (ABCP) continue to be an important component of a money market fund. What is most important is that the manager has sufficient resources to analyse the complexities inherent in securities such as ABCP. We look for strong sponsors committed to the structured market. Within that subset, we want programmes with good asset quality. We’ve always had the resources to analyse ABCP and as a result we invest in ABCP when it makes sense on a relative basis to other securities available in the market as we are constructing portfolios. The current investment in ABCP is perhaps lower than in the past; however, that is a function of the smaller size of the issuance market. The availability of ABCP that meets our requirements today is lower than, say, two or three years ago, as some issuers have left the market completely and others are no longer rated high enough for us to buy. Structured product such as ABCP offers benefits including diversification and a secondary source of repayment. So long as a manager or an individual investor is willing to do their homework and invest the time and expertise in analysing ABCP, it is a security that should not be overlooked. What is the role of money market funds in high net worth investors’ portfolios? For clients who have an allocation to cash, money market funds are a very valuable tool. They are highly liquid (T+1 or T+0 settlement), highly diversified and the underlying portfolio is of very high credit quality. In addition, they offer broad counterparty diversification, mitigating counterparty risk. As a result, money market funds can be a smart investment for an investor’s cash allocation within a broader portfolio or investment strategy as well as good parking place for cash that results from the disposal of assets or for cash that is waiting to be invested. We have seen a large influx of retail and private bank clients in the past two years as these investors demanded best in class money market funds over what may have been offered by their private bank. Some of the traditional offerings to high net worth individuals may have been non-rated in-house funds or straightforward bank deposits. High net worth clients are savvy and they looked to mitigate potential counterparty or credit risk by demanding IMMFA-style money market funds during the financial crisis. What are the risks and benefits of a money market fund that private investors should consider? When choosing an IMMFA money market fund, investors should consider the benefits that come from larger funds as they offer better diversification of both the underlying portfolios and the underlying client base. Other benefits are same day settlement and ease of use. Many private investors are increasingly demanding automation and straight through processing. We are seeing increased demands to make our funds available via the trading platforms that private investors use. As for risks, I would recommend that any investor, be they private investors or large institutions, mitigate manager risk by working with experienced managers who have a strong track record and have large enough money market fund businesses to ensure they are able to maintain the desired in-house credit resources and risk controls. Are the maturity profiles of money market portfolios today generally shorter than in the past? Does this conservative strategy lead to lower yields? IMMFA money market funds are limited to a 60 day weighted average maturity (WAM). Managers will extend WAM when interest rates are falling or the short end of the yield curve is positively sloped, and will reduce WAM when interest rates are rising or if the yield curve is inverted. All of this must be overlaid with the amount of overnight and one week liquidity that a manger requires. When we talk about overnight and one week liquidity, it refers to the securities that are maturing tomorrow or within one week. The IMMFA Code of Practice mandates that members must have a minimum of 5 per cent in overnight and 20 per cent in one-week maturities (ie liquidity). These liquidity profiles may be new for some managers who perhaps did not maintain liquidity at these levels pre-crisis. Since the events of the fourth quarter of 2008, most managers appear to be holding conservative and prudent levels of liquidity to meet investor demand. This increased liquidity profile has given investors greater comfort and looks to be consistent with the IMMFA guidelines. Shorter WAMs and higher liquidity levels may not necessarily lead to lower yields – it all depends on the shape of the yield curve and the mix of legacy assets that are in the portfolio. Are money market funds appropriate to the current environment of low interest rates and high volatility or should investors be looking to a different kind of instrument to obtain a regular yield? Money market funds are a sensible investment option in any yield environment when investors are looking for a safe home for their cash. In terms of volatile interest rate environments, I would argue that the biggest real life stress test of this occurred in the fourth quarter of 2008, when central banks were slashing interest rates globally and Libor was reaching unnatural highs. IMMFA money markets funds in general and JPMorgan in particular truly distinguished themselves during this time. What are the main characteristics distributors should look at when selecting money market funds? I would suggest that distributors look for a manager with a long and successful track record, as well as one who is committed to remaining in the business of managing money market funds. The last thing that a distributor wants to do is to recommend a product that doesn’t have a good history or has a questionable future. One way to determine how important a money market business is to a firm is to look at the percentage of assets in the money market business versus the broader asset management business. You will be able to quickly determine how important the money market business is to the success of the overall asset management firm. Another important evaluation point is the size of the money market business – the larger the business, the better resourced it should be. Distributors should also evaluate the financial strength of the sponsor and its flexibility to act in a crisis event. This may be more nuanced and difficult to analyse, but it’s worth thinking about. Finally, distributors should work with managers who are transparent and responsive when it comes to providing information. If a distributor is responsible for performing due diligence on behalf of its clients, it will need to form a partnership with a manager whose interests are aligned with the distributor in terms of information flow. ^* Source: iMoneyNet, Inc. Foreign exchange rates as of 3 March 2010 applied