Thu, 30 Aug 2012
With the SEC dismissing a plan to reform the money fund industry, Morningstar's Eric Jacobson examines potential risks as well as focus points for investors going forward.
Christine Benz: Hi, I'm Christine Benz for Morningstar. The Securities and Exchange Commission recently scuttled a plan that would have changed the way that money markets funds work. Joining me to discuss the state of the money fund industry is Eric Jacobson. He is director of fixed-income fund research with Morningstar.
Eric, thank you so much for being here.
Eric Jacobson: Great to see you, Christine.
Benz: Eric, let’s discuss what was on the table before the SEC. Among other things, they were considering allowing or requiring money funds' net asset values to float to actually reflect the value of the underlying securities in the money funds portfolio. What other reforms was the SEC reportedly considering?
Jacobson: Well, that's obviously a very big one because part of the goal there was to make things more transparent so people would understand that their net asset values could fluctuate and to protect investors from being left behind if people were to begin redeeming early before 'buck breaking' actually takes place.
The other proposals had to do with requiring money markets to maintain a capital buffer of some kind, which would have been very much like making them into banks, if you will, but that's a tough one certainly. And also they were talking about implementing rules that would require a holdback in the event of redemptions so that the small amount of money that they would be holding back would be a first loss position, if you will, if in fact the fund were to break a buck.
Benz: So, all of this was under consideration to prevent a recurrence of what happened back in the fall of 2008 where one big money market fund, the Reserve Primary Fund broke the buck, meaning that its net asset value did slip below that $1 mark. The idea was that the SEC didn't want any government entities to have to step in and provide a backstop to money market funds as was the case four years ago.
Jacobson: That's right. And I think part of the issue of course, though, was that it wasn't just that they're worried about a single fund breaking the buck, but the potential for what we would call a run on the bank, a run on money market funds, which we sort of had back during the crisis and which was only stopped when the government promised to guarantee against losses which was very much like the guarantee that people already had with their bank accounts.
Benz: So, it sounds like the Treasury Department might be considering what it can do to prevent future situations like the 2008-type environment for money market funds. But in the meantime, Eric, can you address what the risk is, albeit small, for money fund investors? What should they do now?
Jacobson: I would say that in some ways the risks are still the same. It's crucial to remind people that money market funds despite the fact that they are allowed to maintain that $1 mark in their accounting are not guaranteed, and they can lose money. As you said, we've only seen it really happen a couple of times before, but it's especially important now because it's a question of political will. Nobody knows for sure. In fact, we may never see another case again where the government is willing to come in and backstop funds.
That said, I will say that things are a little bit safer than they were prior to the crisis because the SEC has implemented a few changes that have to do with the quality of issues that money market funds can buy. They are restricted to a small amount of lower-quality issues than they used to be, and they've reduced the average maturity requirement from a longer position that it used to be--out at 90 days--now down to 60 days. They made a couple other adjustments that do make money funds a little bit less likely to run into trouble than they used to be, but fundamentally you still have that $1 share issue.
Benz: So by making them shorter-term and higher-quality, the thought is that the net asset value should have less likelihood of being buffeted around?
Jacobson: Exactly, less likelihood of being buffeted around and less risk that the news of a single fund breaking the buck infects other funds and more investors, if you will.
Benz: Eric, if I'm looking at money market funds today, maybe I've got a sweep account that's associated with my brokerage account, what are the key factors I should look at? What we notice when we look at these portfolios is that they're very ephemeral. They change a lot. It's really hard to know what is in a money fund at any given point in time. What are the key metrics that you would advise investors to stay attuned to?
Jacobson: Well, one I would say--and this is probably a little controversial in some corners--but I would say you probably want to stick with a relatively large firm that you think is going to stand by those products and feels that it's a huge business risk if they were ever allowed to let one fail because those are the kinds of companies that are most likely to step in and support that dollar NAV in the event that it even comes close to getting in trouble.
But more broadly I would say it's really important not to necessarily go after the highest-yielding fund because there is a pretty direct correlation between how much risk a fund takes on at this level and how much yield it's able generate. And when I say at this level, I mean this very, very short-term world of money market securities because there is almost always a very, very directly related risk/reward trade-off.
The flip side of that is you definitely want to look at costs. This is certainly something we say all the time about mutual funds, but it's even more important with money market mutual funds because there is a very, very direct relationship between every penny that leaves that fund and every bit of income that you are not going to get as a result and there's a perverse incentive on the part of anybody who is charging a lot for their money market funds potentially to take on more risk so that they can compete on yield. So, again, just to summarize, you really have to watch costs and don't chase yield too hard in this space if safety is your main concern.
Benz: And the idea of going with a bigger firm, as you said, Eric, is that if in a worst-case scenario the fund did have trouble with some of the securities in the portfolio, the advisor could actually add its own money to the fund to top up that NAV back to a $1.
Jacobson: That's right. It has happened a number for times in the past, and the big knock on the smaller, less well-known organizations is that they might not have the capital to step up and do that.
Benz: The last topic I want to cover with you, Eric, is looking at where money funds stand today, where yields aren't appreciably above other cash securities, and you do not have that FDIC protection or necessarily a guarantee of a stable NAV. I think you might be wondering why bother with money market funds. What's your counsel to investors who might be tempted to pull their money from their money market funds at this time?
Jacobson: I would say that if income is your top priority, and you're able to find something else that you think is safer like a bank certificate of deposit or what have you or any other insured account that is offering a more generous return, if you can find something like that and it offers the safety that you're looking for, there is no reason that you have to go with a money market fund.
The one thing I would say that does fall on the side of the money market funds is if we are in a situation where yields at the short end do eventually start to rise, money market funds would be among the first vehicles to recognize that and to actually adjust to it and see their own income delivery go up. In other words, when short-term rates are rising, the money market funds are usually are first to benefit from that trend.
Benz: Eric, well, thank you so much for sharing your guidance on this topic. It's an important one for a lot of investors. There is a lot of cash in money market funds. So, thanks for being here.
Jacobson: My pleasure, Christine. Thanks.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.