Short-term funds an ideal temporary home for cash

How has the concept of money market funds in Europe evolved over the past couple of years, and have regulatory changes provided greater transparency?

Although the money market fund industry has a fairly short history in Europe, uptake has grown significantly in recent years. However, the term ‘money market fund’ can mean several different things in the pan European landscape – from the most conservative, AAA-rated stable Net Asset Value (NAV) funds managed in line with the guidelines set by the Institutional Money Market Funds Association (IMMFA) through to more risky and less regulated ‘cash’ funds.

The European Securities and Markets Authority (ESMA), the pan-European regulator, previously known as The Committee of European Securities Regulators (CESR), has recognised this difference in risk with its two-tiered approach to money market fund classification. ESMA refers to riskier funds that have a longer duration and that may take significant credit risk as ‘money market funds’. The stable value AAA-rated IMMFA-style funds that J.P. Morgan manages are similar to those classified by ESMA as ‘short-term money market funds’.

While ESMA allows money market fund portfolios to have a weighted average maturity (WAM) of up to six months and a weighted average life (WAL) of up to 12 months, short-term money market funds are restricted to a WAM of up to 60 days and a WAL of less than 120 days. ESMA short-term money market funds are largely constant NAV funds – where the published NAV of the fund is always 1.00 in principle. Variable NAV funds, on the other hand, are required to be marked to market daily and so the capital value is likely to fluctuate.

The trend in Europe over the last few years has been towards investing in the more conservative short-term money market funds. Indeed, IMMFA-style funds have seen strong inflows compared to non-IMMFA funds. Since January 2007 IMMFA funds have grown in size by some 70 per cent*, while non-IMMFA funds have fallen by nearly 7 per cent**. This increased demand for short-term money market funds is, in part, due to the greater scrutiny on credit risk that arose as a result of the financial crisis, as well as to recent concerns over the exposure of banks to eurozone sovereign debt.

What do short-term money market funds typically invest in?

IMMFA-style money market funds such as those offered by J.P. Morgan Asset Management, typically invest in the highest rated, short-dated money market instruments. These may include overnight bank deposits, term bank deposits, bank CDs, floating rate notes, commercial paper, asset backed commercial paper, highly-rated corporate debt and repurchase agreements (repos).

Different managers will have varying degrees of resources available to conduct credit analysis and risk management. Investors should ask questions of their manager to ensure they are comfortable with the resources and controls the manager has in place. Managers should no longer just accept a credit agency rating, but should be carrying out in-house credit analysis on all securities in their portfolios.

How do you pick the right issuers? Is credit quality the most important selection criterion?

Credit quality is critical before an issuer gains approval for potential use in our short-term money market funds. Our credit research team evaluates credits within their particular sectors and identifies investment opportunities by utilising a variety of qualitative and quantitative inputs from a range of internal and external research.

Following this, there are several other factors that must also be considered. For example, we look at how an issuer trades in the secondary market and the current concentration within a portfolio. The financial crisis saw the emergence of a further level of analysis for banking issuers following the implementation of government guarantee programmes. Although many governments were more than willing to provide assistance to their banking systems, not all had the means to do so.

What is the role of short-term money market funds in high net worth investors’ portfolios?

As the world recovers from the financial crisis, many private investors have started to raise their exposure to equities at the expense of cash. However, a solid portfolio allocation to cash remains important, particularly given the recent rise in macroeconomic and geopolitical risks.

For investors looking for secure and liquid homes for their cash, stable NAV short-term money market funds are a very valuable tool. They are highly liquid (T+1 or T+0 settlement), their underlying portfolios are of a very high credit quality, and they offer broad issuer diversification, mitigating counterparty risk. In addition, some short-term money market funds also offer accumulating share classes, which could potentially be beneficial from a tax perspective.

As a result, short-term money market funds are often used by investors for cash allocations within a broader portfolio or investment strategy as well as a safe temporary home for cash that results from the disposal of assets or for cash that is waiting to be invested.

What are the risks and benefits of a short-term money market fund that private investors should consider?

When choosing an IMMFA-style 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 increasing demands for automation and straight through processing, and this is translated to requests to make our funds available via the trading platforms that private investors and distributors use.

Investors, be they private investors or large institutions, could mitigate manager risk by working with experienced managers who have a strong track record and have large enough short-term money market fund businesses to ensure they are able to maintain the desired in-house credit resources and risk controls.

Are short-term money market funds appropriate to the current interest rate environment or should investors be looking to a different kind of instrument to obtain a regular yield?

Short-term money market funds can be a sensible investment option in any yield environment, particularly investors who are looking for a safe home for their cash combined with same day access. In terms of volatile interest rate environments, compared to variable rate bank accounts, actively managed short-term money market portfolios can move along the yield curve to lock in higher yields when rates are falling. They can also benefit quickly from higher yields when rates are rising, which can prove beneficial when compared to fixed term deposits.

Investors looking for maximum security should choose AAA-rated traditional or government debt funds. However, in the current low interest rate environment, high net worth cash investors may look towards non-IMMFA money market funds and even ultra short-dated bond portfolios to provide enhanced yield opportunities. We have also seen some investors opting for foreign cash markets to pick up additional yield (clients should be aware of any associated foreign exchange risk on such a transaction). As the largest provider of institutional AAA-rated short-term money market funds, J.P. Morgan also offers a comprehensive range of solutions across the breadth of the short-term cash space.

What are the main characteristics distributors should look at when selecting short-term money market funds?

Distributors should 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 short-term money market funds. The last thing a distributor wants to do is to recommend a product that doesn’t have a good history or has a questionable future.

Distributors should also 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.

Furthermore, distributors should look to select funds with the best liquidity profiles. Some funds, such as those offered by J.P. Morgan Asset Management, offer intraday settlement with multiple payment batches, so investors can have access to their cash whenever they need it.

Finally, it’s important that investors can invest easily and flexibly through a range of popular trading platforms, such as EMX (Fund Settle) and Clearstream.

* Source: iMoneyNet as of 31/01/2011

** Source: Lipper as of 31/01/2011

This is a financial promotion. The value of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. The information provided is for use by professional investors only and not for public distribution. The opinions expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. This material should not be considered by the recipient as a recommendation relating to the acquisition or disposal of investments. This material does not contain sufficient information to support an investment decision and investors should ensure that they obtain all available relevant information before making any investment. Issued in the UK by JPMorgan Asset Management (UK) Limited which is authorised and regulated in the UK by the Financial Services Authority. Registered in England No. 01161446. Registered address: 125 London Wall, London EC2Y 5AY.