Money Market Funds Evolving from Market Turmoil
A year ago, the turmoil in the global credit markets sparked by the US sub-prime mortgage crisis spilled over into money market funds (MMFs), which have traditionally been considered by investors to be among the safest and most liquid investments in the marketplace. While concerns last summer about sub-prime mortgages initially impacted the long-term securitisation markets, investor concerns quickly extended to other market sectors including the US$1.2 trillion short-term asset backed commercial paper market, which was a significant asset class for many taxable MMFs leading up to the credit market crisis a year ago.
At Invesco, we were flooded with shareholder calls from corporate treasurers and other institutional investors trying to understand what was in their MMF and with concerns about the liquidity in the marketplace. Corporate treasurers have invested in MMFs for years and have not had to be concerned or answer questions regarding the composition or the safety of their money market investments.
Some MMF portfolios have experienced an influx of cash assets since the credit crisis began last summer. For example, cash assets under management at Invesco increased 41% to US$91bn through May 2008. This worldwide asset growth is due to investors searching for experienced fund managers who have managed to stay out of the headlines, which ultimately is attributed to stringent and robust credit and risk management processes. Funds that did not have exposure to troubled securities have been unaffected by the credit crisis.
In contrast, some MMF portfolios had exposure to riskier asset-backed commercial paper programs, backed predominantly by sub-prime mortgage loans or securities issued by structured investment vehicles (SIVs) with concentrations in sub-prime mortgage related assets. Additionally, there were many extendible securities in the marketplace that did not have sufficient liquidity support structures to ensure timely investor repayment in the occurrence of a market disruption or other non-credit related events.
In some instances, most notably with non-bank affiliated structured investment vehicles and extendable asset-backed commercial paper programs backed by mortgage assets, the inability by some issuers to issue new debt to replace maturing short-term debt resulted in defaults or helped trigger a liquidation of an issuer’s underlying assets into an extremely difficult and price-challenged market environment.
As a result of events during this period, some MMFs experienced defaults and losses related to their portfolio holdings of some of these troubled securities. In certain instances, some fund advisors have injected capital or have provided other forms of financial support in order to preserve the US$1 NAV of their MMF portfolios and to maintain investor confidence.
For many years, investors were only focused on the yield of their MMFs, but security and liquidity quickly became their primary concern during the recent credit crisis. In many respects, recent market events have underscored the significant investment manager and product differentiation in a marketplace that investors once viewed as being relatively homogenised.
Based on the dispersion of credit performance during this period, it became abundantly clear that not all MMFs are created equal and that some advisors had deviated from their primary mandates of ensuring security and liquidity for their investors. The credit crisis has created an inflection point in the MMF industry regarding how investors view MMFs, perhaps permanently. Since last summer, our cash management team has conducted hundreds of meetings with investors who have been surprised by the impact of the credit market crisis and now have a heightened awareness of the risks in their MMF investments.
The unprecedented market environment and the very substantial losses experienced by some funds have caused senior management of many investment advisors to perhaps re-evaluate their MMF portfolio management capabilities, credit risk management processes, organisational structures, and perhaps even the viability of their future involvement with managing MMFs. Many firms may realise during this self-evaluation process that they do not have or may not be willing to invest in the resources required to be a successful long-term player in the money market business. This issue may gain greater emphasis as the SEC looks to overhaul Rule 2a-7 with a greater focus being placed on a fund’s ability to meet the ‘minimal credit risk’ criteria for portfolio holdings.
At the one-year anniversary of the credit market crisis, investors continue to assess the contagion damage that has now impacted everything from financial institutions to auction rate securities to the student loan market, with Bear Stearns being arguably the highest profile victim of the crisis to date. Since last summer, financial institutions have reported more than US$400bn in credit market related losses and have raised in excess of US$320bn in new capital to help offset those losses.
The US Federal Reserve, foreign central banks, and other regulatory authorities have also taken unprecedented measures to help improve market liquidity and stability. The combination of government intervention and recapitalisation efforts in the financial sector has improved credit market sentiment and stability from the lows experienced in March 2008 following the Federal Reserve facilitated bailout of Bear Stearns.
However, given lingering investor concerns about market liquidity and the potential for further losses in the most problematic sectors of the credit market, MMF investors understandably have continued to remain vigilant in the current market environment. They want greater transparency in portfolio holdings, AAA credit ratings on portfolios, a robust and experienced credit team that is separate from portfolio management, appropriate maturity structure to ensure fund liquidity, and greater communication and commentary from fund managers.
The Invesco investment philosophy for MMFs has always focused on safety, liquidity, and then yield as a byproduct. Everybody you talk to about MMFs will focus on these three philosophical tenets. The interpretation of those three words is the key to the success of the MMF business. We used to say security is the simple equation that portfolio assets, plus portfolio configuration, plus operational risk (compliance, regulatory, actual security settlement, etc.), has to equal a dollar.
The ability of investment managers to accurately predict future market events or the timing of the next financial crisis remains limited. However, by identifying and selecting investment managers that pursue a conservative, proven investment approach that focuses on capital preservation and liquidity, investors can better position the cash portion of their portfolios for unanticipated and unwelcome changes in the marketplace.