Money market funds hit by perils of low rates and rising regulation

Money market funds — short-term, liquid investment vehicles – have been beleaguered by low rates, a contracting universe of investibles and spiralling regulation. Ever since the Primary Reserve Fund collapsed in 2008, the focus on the capital preservation and liquidity of these funds has been relentless, to the point, critics say, of overkill.

A great deal has been achieved to make the terminology more consistent and the underlying holdings more transparent. The SEC (Securities and Exchange Commission) introduced its 2a-7 rules in 2010 to establish new standards for a fund’s portfolio liquidity, weighted average maturity, asset quality, and the publication of holdings on websites. Then last year, the Investment Management Association began to monitor the holdings of the money market (MM) sector funds in the UK, using the definition outlined by Esma (the European Securities and Markets Authority).

However, further regulatory tightening continues to be debated by the SEC such as forcing funds to adopt a ‘floating’ net asset value and to accumulate a capital reserve to cushion against losses. This could prove a step too far, creating a massive accounting challenge and lead to a contraction in the market. Corporate treasurers could pull more than 27 per cent or $700bn (€535bn) of their holdings from the sector, according to a survey by ICD, a provider of MM fund trading and risk-management tools.

“Funds already offer investors three layers of security,” explains Reyer Kooy, UK head of institutional liquidity management at DB Advisors. “Firstly via the Ucits wrapper, then via their definition as a money market fund by Esma and thirdly, by ratings from agencies such as Moodys and Fitch. They also follow the code of conduct of IMMFA (Institutional Money Market Fund Association). This escalating regulatory environment has been caused by a perception that money market funds are part of the shadow banking structure.”

TOUGH TIMES

The market is already suffering from low relative rates, making it tough to generate revenues. The £1.9bn (€2.3bn) Henderson Liquid Assets fund was transferred to DB Advisors last March as part of the group’s strategy to exit a number of non-core legacy businesses. In April, Standard Life followed suit, a year after it was fined £2.4m for failings in managing its pension sterling fund which prompted the closure of its sterling, euro and dollar global liquidity funds.

“Money market funds have a high transparency, but if the fund space contracted and people again started to invest directly with banks, then that could take a lot of transparency out of the system, because it is hard to know what banks are holding on their balance sheets,” says David Callahan, head of money markets at Lombard Odier Investment Managers.

“The MM fund sector in general does not want variable NAVs (net asset values). This is a real issue because if a greater number of investors went directly to banks, where would the banks put that cash? Banks have been told to be less reliant on short-term deposits due to the mismatching between their assets and liabilities but they could be forced to take on much more short-term liabilities which goes against the regulator’s desire. The regulators need to understand this imbalance.”

For the investor, the fund structure has obvious advantages over depositing large sums with individual banks that are above the size at which they are guaranteed under the relevant compensation scheme. In the UK for example, the Financial Services Compensation Scheme compensates up to £85,000 per saver, per authorised institution. In comparison, money market funds generally provide the security of diversification across as many as 50 underlying exposures, with perhaps up to 100 securities in a buyline.

CORPORATE ASSETS

Fortunately, MM fund assets remain bolstered by the corporate sector which has been running a high level of cash for several years. “Corporates continue to have bloated balance sheets, and are not yet putting the capital to work, with the result that they’ve had high levels of cash for a number of years and these levels are not going away,” says Jim Fuell, head of global liquidity EMEA at JP Morgan Asset Management. “These levels are the new paradigm; the new normal.”

However, the supply side has become more challenged. “What we’re seeing is changes in the appetite for short-term funding – primarily by banks which need to extend the maturity of their debt because of the requirements regarding their liquidity buffers,” says Jonathan Curry, global CIO -liquidity at HSBC Global Asset Management.

“This regulatory change has meant their appetite for short-dated borrowings is gradually decreasing. This is exacerbated by a decrease in the banks’ appetite for wholesale funding – the nature of regulation is encouraging banks to get more of the funding for the retail client base. The ECB’s recent 3-year Long Term Refinancing Operations (LTROs) have also given banks another source of funding that many are taking up,” he explains.

“On the demand side, money market funds have reduced the number of approved issuers they are willing to lend to as their opinion of credit quality has changed. So here we have big changes in the supply and demand dynamics which, everything else being equal, means lower returns for investors in the money markets,” adds Mr Curry.

Rating agencies continue to downgrade banks and sovereigns below the minimum required for MM funds. For example, Moody’s announced in March that it had put 114 on a negative outlook but the level of downgrade was unclear at the time of going to press.

“As so many issuers’ ratings have fallen, now under fund rules one can put only a reduced holding in certain issues, which means spreading the fund over greater number of names and requires greater analysis of a wider set of names,” says Wim Veraar, head of the money markets team at ING Investment Management.

“A crucial difference now however is the yawning gap between the 0.3 per cent paid on overnight deposits and 10-year rates which are 1.9 per cent. In Europe there is also discussion of additional taxes on financial transactions. A tax on a 0.5 per cent return could result in some flight to bank and insurance products which are exempt. This new tax is up for discussion; the point is not to underestimate the pressure on the financial markets.”

PUTTING CASH TO WORK

These low returns have focused investor attention on what they are trying to achieve with their cash balances. “The dialogue we have with clients is that they are now thinking more about the nature and attributes of the cash they have,” adds JP Morgan’s Mr Fuell.

“Segregated mandates can offer a wider range of flexibility and this can prove important when you are running big balances. We are encouraging clients to go through the healthy process of understanding the nature of cash and whether they really need the same day liquidity and capital preservation afforded by a MM fund, or whether it could be to put to greater work generating a higher level of return,” he explains.

“Some of the regulatory change that has happened at the short end means that SNAV funds have arguably become safer in the last few years but they are also operating under more constraints. Investors should consider whether they really need it all liquid or whether they could move some of it outside the time occupied by MM funds – that is from overnight cash to a 6 to twelve month time-frame or even one year and beyond,” adds Mr Fuell.

“We feel that clients should consider segregated mandates but there is hesitancy,” says Marcus Littler, director of institutional liquidity sales at BNY Mellon Asset Management.

“One aspect people overlook is the opportunity risk, that they might miss additional income and yield in not being prepared to go further out the yield curve. Costs should be similar, although a custodian will be required. The opportunity basket has become narrower, particularly in financials because of the intended and unintended consequences of regulation. At a time when bonds of one-year average maturity duration would yield an additional 30-50 bspts over a MM fund, we think clients should look further afield,” he explains.

“Normally when rates get to their bottom, one will see cash move to riskier names or put to use for example in M&A. But the perspective on Europe is that there is a long road ahead and austerity is needed, so more cash is being held than has been the case historically,” says Mr Littler.

“The biggest challenge is to try to build a portfolio where the risks are well balanced but the return remains attractive,” says Luigi Fallanca, head of fixed income of Eurizon Capital.

“With the rate so low in the short part of the curve (German bills are close to zero yield and dollar treasury bills yield is below 0.20 per cent) due to the expansionary monetary policy followed by the main central banks – the ECB, BOE, FED, and BOJ – it is very challenging to assure an interesting return to the investors keeping in mind that MM funds have to preserve capital, maintain liquidity and select assets that are not too risky.”

Investors seek reassurance

“In the past, money market funds were treated like bank deposits but in recent years clients have needed more handholding to look at the risks embedded in the securities by instrument and duration,” says Delyth Richards, head of fund research at Kleinwort Benson.

“If people have lots of cash, then they will want to know how much is with each lender. The key for investors is to pick funds that offer full transparency, such as Deutsche which gives full transparency on all its holdings on a daily basis. There is a need to pull back the layers on the onion by duration, sovereignty and types of instrument,” he explains.

“We have been de-risking portfolios and reducing equity positions, and in terms of being out of high risk equity markets, we have sometimes preferred to be holders of gold rather than cash. Sovereign risk is what we are most concerned about.”

One characteristic of the money market space that sets it apart from all others is the lack of tolerance for a decline in capital.

“Clients are ‘headline averse’ rather than having significantly increased their understanding,” argues David Callahan, head of money markets at Lombard Odier Investment Managers.

“Very often we need to appease clients because we are managing according to people’s worst fears rather than with regard to economic fundamentals.”

For the time being, many UK investors will continue to look for a rating on a fund because until July 2011 there was no specific money market regulation or even definition outside the US market. However, it is possible that over time, as regulation gets better understood, investors will no longer require the comfort a rating may provide.

Meanwhile, low rates of return have prompted demand for bespoke cash management solutions to enable investors to take advantage of issues that are further out the duration. High net worth clients are generally being encouraged to think about the nature of their cash and whether some of it could be put to work generating a higher level of return.

VIEW FROM MORNINGSTAR

Still something for investors?

The days of getting up to 5 per cent a year with money market funds are over. One of the main reasons is the disappearance of the ‘dynamic money market’ funds that incorporated assets such as equities, bonds or derivatives. These funds disappeared after the 2007-2008 financial crisis when new regulation barred the use of the term ‘money market’ alongside any other word. As a consequence, many dynamic money market funds closed while others were reclassified as ‘absolute return’.

Secondly, money market assets (very short-term bonds) are increasingly less generous. Low interest rate levels have driven down the returns of money market funds, with the annual return for the EONIA index now below 1 per cent.

It is difficult in such conditions to provide good returns. Regulation adopted at the European level for the definition of money market funds is very tight and managers have to be very cautious when considering what to include.

The DWS Rendite Optima Four Seasons fund, which delivered more than 1 per cent over the past year, had to go to very short-term corporate debt. The BlackRock Institutional Euro Liquidity € – with a return of 0.66 per cent – has a shorter duration globally because none of its assets are due after 2012. In fact, the fund is part of the Morningstar Money Market Short Term category, which has even more restrictions.

Finally, let us consider funds with extremely low levels of returns such as the JP Morgan Euro Government Liquidity Fund, which returned less than 0.20 per cent. It invests primarily in government bonds with a duration of less than seven months. At that level, and with a TER of 0.65 per cent, there is not much left over for investors.

Gordon Rose CIIA, ETF analyst, Morningstar, Inc