Improved Communication: A Vital Component of MMF Reform
A deluge of suggestions for reforming and increasing regulation of money market funds (MMFs) still follows in the wake of the troubled credit markets. From the Group of 30 Working Group on Financial Reform report, entitled ‘Financial Reform: A Framework for Financial Stability’, to the Investment Company Institute’s (ICI) report of the Money Market Working Group (MMWG), to the Committee on Capital Markets Regulation report, entitled ‘The Global Financial Crisis: A Plan for Regulatory Reform’, the debate about how to shore up the money fund industry continues.
These various groups and others have proposed controversial changes such as moving to a floating net asset value share price, requiring capital reserves and bank-like structures, requiring explicit insurance protection against impaired assets, adding FDIC-like insurance and making permanent the government guarantees. There have also been other, less contentious, suggestions designed to reduce risk and improve disclosure and transparency. While many of the recommendations have merit and would improve the orderly functioning of the money market industry, some crisis-recovery strategies tend toward overreaction by suggesting substantial new and potentially onerous rules, requirements and regulations.
Even as the market awaits further regulatory direction from the US Securities and Exchange Commission (SEC), one thing is clear: investors cannot rely on regulation alone to protect them. Regulation cannot replace communication. Investors need to be proactive in seeking the information and tools that will enable them to improve their investment process. Discussions about the money fund industry hinge on the need for increased communication between fund managers, investors and regulators, particularly in the form of improved transparency and reporting. In the end, more effective communication may better serve investors than more stringent regulation. The use of technology to deliver meaningful reporting and analytics will likely prove to be the most effective way for fund managers to communicate with investors and for regulators to monitor fund activities.
George Bernard Shaw (1856-1950), the Irish playwright, noted “The problem with communication … is the illusion that it has been accomplished.”
Historically, pooled investments – including money funds – have provided only modestly detailed information into the underlying investments and activities of the fund. The assumption that investors could understand and interpret the risk and activities of the fund with such limited information wasn’t challenged in the relatively benign environment preceding the recent market disruption. However, as the crisis ensued there were sudden calls for increased disclosure and transparency – more detailed information on a timelier basis. To their credit, some fund sponsors sought to provide additional information to investors to alleviate concern. This included more timely reporting of portfolio holdings information along with better explanations of specific fund exposures. Riding on the coat tails of this increased transparency, investors’ expectations have risen.
For several funds, the significant redemption pressure they felt was not necessarily caused by distressed securities in their portfolios. Instead, contributing factors, such as the level of concentration of investors, and the fear of risk of loss or lack of liquidity by investors were the culprits. In the first couple of weeks following the Lehman bankruptcy, as reported by the iMoneyNet weekly Money Market Insight report, more than US$500bn migrated from general purpose MMFs into government funds or out of money funds altogether.
The ICI MMWG report specifically recommends several ways to improve communication between funds, investors and regulatory authorities, particularly in the form of increased disclosure and reporting. While rulemaking and enforcement of these recommendations is under the purview of the SEC and other regulatory bodies, the ICI recommends “that money market funds can and should implement them immediately on a voluntary basis.”1 It is noteworthy to consider how the various proposals relate directly to the objectives of MMFs, which are: safety of principal; liquidity; and income. The demand for increased transparency and disclosure relates specifically to understanding the stability of the net asset value of the fund and portfolio liquidity.
Given the liquidity constraints brought on by the recent market crisis, most investors are concerned with a fund’s liquidity position. Does the fund maintain adequate liquidity to satisfy investor demand? How much liquidity is maintained overnight? In its recommendation 7.1 regarding portfolio liquidity requirements, the ICI MMWG proposed that rule 2a-7 should be amended to require taxable MMFs to meet a minimum daily liquidity requirement of 5% of assets (7.1.1). It also proposed that all MMFs meet a minimum weekly liquidity requirement of 20% of assets (7.1.2). Without difficulty, funds could report their liquidity allocations and communicate this information to investors in easy-to-understand graphs and charts as part of a robust, web-based total fund reporting solution.
Furthermore, the ICI MMWG recommended that funds regularly ‘stress test’ the portfolios based on estimates of credit risk, interest rate movements and shareholder redemption activity (7.1.3). This particular recommendation may be a bit more challenging to address – at least in a meaningfully consistent way for investors. Fund advisors will likely have independent or proprietary models and assessments for credit quality, portfolio risk and cash flow management that will differ across providers. They will certainly have differing views on interest rate movements and their impact on the underlying portfolios. Regardless of each fund’s specific views of these factors, the assessments will be more meaningful to investors to the degree this information can be standardised and compared across funds. This will require very transparent reporting of detailed portfolio information and the involvement of third-party data reporting and analytics vendors that can develop and deliver solutions to the investing public.
Nothing could be more fundamental than an investment manager understanding the needs of the client and the client understanding the investment product. In recommendation 7.4, the ICI specifically addresses client concentration risk and proposes that funds and investors improve their communication to better understand investor redemption practices and liquidity needs. They propose several steps to establish a robust know-your-client (KYC) process that serves to protect the interest of the client, the fund and other shareholders (7.4.1). Additionally, the ICI specifically recommends that funds make a monthly online disclosure to a website of their client concentration by investor type (7.4.2). This creates an interesting challenge because no fund has ever provided client-concentration disclosures or reporting in any sort of consistent fashion – for most, the methodology for categorising clients hasn’t even been determined.
It may be more complicated to differentiate between institutional and retail investors than one may think. What about alternative distribution platforms? Identifying a client who invests directly with the fund or via a direct model portal could be easy, but identifying underlying client investors in an omnibus portal relationship could be challenging. Likewise, the investment/redemption activities of retail, high net worth or small institutions individually may not have much of an impact, but in aggregate could meaningfully affect a fund’s liquidity position or investment strategy. It seems that the primary focus of the recommendation is to identify situations where a handful of large investors (particularly institutions) could materially and adversely affect the liquidity position and the underlying net asset value (NAV) of the fund because of their redemption activity. Investors need to understand the risks associated with funds that have a high degree of client concentration versus those that have a well-diversified client base. Technology will play a pivotal role in identifying, tracking and reporting on these activities by investor type.
Currently MMFs are required to publicly file their complete portfolio holdings at least semi-annually with the SEC. Except in certain specific circumstances, portfolio holdings information must be made publicly available to all investors at the same time, not selectively disclosed to certain investors but not to others. The ICI MMWG has analysed the issues related to disclosure of portfolio information and recommends (7.6.2) that MMFs be required to post the entire portfolio holdings to a website each month within two days of month end. The ICI went on to state: “Funds should reassess and revise the disclosure of risks that they provide to investors and the markets. The SEC should require MMFs to provide monthly website disclosure about portfolio holdings, which will allow third-party analysts and commentators to compare MMFs.”2 Funds will have the discretion to post their holdings on a more frequent basis if they choose. Many investors, particularly larger institutions, want to monitor their fund holdings on a regular and consistent basis and would like to be able to aggregate this information with the rest of their investments, including separately managed accounts. This type of regular disclosure will also allow third-party analytics and reporting providers to make meaningful comparisons of money funds and highlight certain characteristics that are of interest to investors and the market generally. As illustrated in the following diagram, third-party technology reporting and analytics providers play a critical role by delivering enhanced reporting which results in improved communication.
For the benefit of the investing public, the regulatory entities, the fund companies and investors need to come together to tackle the key communication issues: the frequency of reporting; the reporting format; and the fund data that should be required in the reporting and disclosures. Having access to this type of information will further help investors improve compliance, risk management and other important aspects of the investment decision-making process. As the ICI states: “It is hoped that these third parties will use this, and other disclosure recommendations discussed in this report, to help guide the investing public about the risk characteristics of particular MMFs.”3
Increased disclosure and transparency is a good thing, but will only be valuable to investors if it is actionable. The information must be relevant, timely, objective and standardised to the greatest degree possible. The typical institutional money market investor, who is investing in multiple funds from a variety of fund managers, often has to undertake painstakingly difficult manual processes to gather, assimilate and analyse the information they need when monitoring and making investments. Therefore, the disclosure will only have value if it is consistent with investors’ reporting requirements so as to be comparable between providers. To best serve the investing public, the portfolio holdings disclosures need to be in web-based formats that can be manipulated quickly and efficiently by a variety of reporting technologies and integrated into client reporting platforms. Clients want solutions that are automated, allowing for apples-to-apples comparisons that better enable the investment decision-making process.
The ‘improved communication’ described here is the process of turning fund data into useful information that enables investors to make better decisions about their fund investments and enables regulatory bodies to monitor the market more effectively . Improved communication creates a win-win scenario for all constituents. As fund managers choose to adopt these measures and provide a greater degree of transparency, they will reap the benefits of improved client relationships. Transparency will instil confidence in clients, and an informed client is typically a better client than an uninformed one. Managers should see their business increase as investors choose to invest with those they know and trust. Greater transparency and disclosure may curtail the need for more onerous regulation and preserve the value of MMFs as a vital liquidity management tool. The entire money fund industry will benefit as confidence increases in what has been an enormously successful product.
1 Report of the Money Market Working Group, Investment Company Institute, 17 March 2009.
2 ibid.
3 ibid.