Short-term Investors Get Smart
Over the past 12 months, unprecedented turmoil in the global credit and financial markets has driven a widespread retrenchment of risk by short-term cash investors, especially corporate treasurers. Although at first this retrenchment was deemed to be a temporary reaction to the credit crisis, the resulting flight to quality can no longer be viewed as merely a cyclical repositioning of risk, with cash investors ready to revert to their former investments once normality returns. Instead, the events of the last year appear to have changed the way investors think about their cash investments permanently.
The strategies that have benefited most from the past year’s market dislocation have been short-term bank deposits, government securities and AAA-rated, stable net asset value (NAV) money market funds (MMFs). The reason for the choice of investment has been mostly linked to risk. Bank deposits, for example, come with an explicit guarantee from the borrowing bank, although liquidity concerns for many of the world’s leading financial institutions have continued to worry investors.
Government securities, on the other hand, offer the liquidity and safety that most investors desire, but at a significant cost in terms of yield give-up. In contrast, AAA-rated MMFs offer access to a diversified mix of short-term securities in combination with daily liquidity and an attractive yield (especially in times of rising rates). This has made MMFs the most popular way for short-term investors to reduce risk while also maintaining the highest level of liquidity and a competitive yield. However, distinguishing these low risk funds from other, more risky, so-called MMFs has been very difficult at times.
In contrast, the area of the market that has seen the most dramatic decline in usage over the last year has been direct investing into commercial paper. As the economic environment has slowed and the prospect of corporate downgrades, or even defaults, has increased, the majority of corporate treasury investors without in-house credit analysis capabilities have been reluctant to blindly buy the securities offered to them on broker sales lists.
As you can see in Figure 1, the largest flows have been into MMFs, with US$514bn being invested. This is a net increase of 32%. The second largest flows have been into bank deposits and sweeps, with a total of US$279bn invested – a net increase of 36%. Commercial paper has seen the largest net loss, of US$623bn. This equates to a 75% decrease.
AAA-rated stable NAV funds are characterised by their three main objectives, which are (in order of importance) daily liquidity, the highest level of security and a competitive yield. To qualify for their AAA rating, a fund’s portfolio must be extremely high quality (the majority of assets should be A-1+/P-1) as well as having a short weighted average maturity (WAM) of less than 60 days.
One of the more positive changes to the MMF industry has been the clearer distinction between enhanced, ‘cash plus’, or dynamic MMFs and AAA-rated, stable-NAV MMFs. AAA-rated MMFs have also been defined as Qualified Money Market Funds (QMMFs) by the industry’s self-regulating body, the Institutional Money Market Fund Association.
QMMFs are the most conservative of the broader ‘MMFs’ category, which is widely used in Europe to describe everything from stable NAV funds to enhanced yield funds, short-term bond funds and even total return style funds. The differentiating factor between all of these types of fund has always been liquidity. QMMFs are buy-and-hold strategies that invest solely in securities maturing in the near-term. Therefore they do not normally rely on the presence of market participants to buy securities from them in order to meet the liquidity demands of their shareholders.
This sole focus only on very short-maturity instruments is an important distinction between QMMFs and other, more risky MMFs. For example, longer-term enhanced, dynamic or total return funds implement active strategies that can buy securities maturing as far out as 30 years. As a result, they’ve always relied upon market liquidity in order to meet shareholder redemptions when needed. Such strategies worked perfectly well until market liquidity vanished in the summer of 2007, forcing the fund’s to sell securities at discounted prices. These losses were then passed onto investors.
Short-term investors have not only become wise to the types of fund that are available, but have also begun to better differentiate between QMMFs and the asset manager offering them. In an area of the industry that had become increasingly commoditised and driven by a focus on yield alone, now risk-related factors play a much larger role in fund selection. In particular, investors are increasingly focusing on fund size, portfolio holdings and the strength of the provider.
The size of the fund, in particular, directly addresses large investors’ fears of being a big fish in a small pond. If you make up too much of the fund, how confident are you that adequate liquidity will be provided?
Also, investors are now much more educated in the short-term markets, with many demanding to see a full list of a fund’s portfolio holdings in a timely manner, along with an explanation of why certain securities are held. Asset managers no longer have the luxury of hiding behind the claim that their portfolio holdings are ‘proprietary’ – they need to show their hand before investors will trust them.
Finally, and perhaps most controversially, the financial strength of the provider is now frequently considered. Although an investment in any mutual fund is ‘ring-fenced’ as far as the fund provider’s balance sheet is concerned, the funds themselves are not guaranteed by the asset management company, or the parent bank entity, if one exists. Despite this, many investors believe that if the stable NAV of an AAA-rated fund is in jeopardy, the provider will step in to avoid any losses being passed onto shareholders. Assuming this assumption is correct, the provider can only do this if their balance sheet gives them the means to do so – hence a focus on the provider’s financial strength.
Clearly, the last 12 months has been a momentous time for short-term investors. The focus has moved from a focus on yield towards an environment of extreme risk-aversion. This has caused a large change in investor mindset and a corresponding change in the types of instrument used for short-term cash holdings.
AAA-rated MMFs have been a major beneficiary of this change because of their ability to offer very high levels of security while also maintaining the highest level of liquidity and a competitive yield. However, even among MMFs, investors have become much more discerning, seeking out only the largest funds with the highest credit ratings, most secure holdings and, in many cases, offered by the strongest providers. These changes have been profound and are likely to be permanent.