Wed, 12 Jun 2013
Regardless of which SEC money-fund reform gains approval, retail investors will still find safety in this asset class, says Morningstar's John Rekenthaler.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The Securities and Exchange Commission recently issued a few proposals related to money market funds. Joining me to discuss them is John Rekenthaler. He is vice president of research for Morningstar. John, thank you so much for being here.
John Rekenthaler: Thank you, Christine.
Benz: John, let's start with a little bit is stage-setting. Let's talk about why the Securities and Exchange Commission is looking at the money market fund industry, and why it thinks that perhaps some tighter regulations are in order?
Rekenthaler: Sure. It takes us back to 2008, as so many things do. That was a momentous year for money market funds where the Reserve Primary Fund broke the buck, as the saying goes, in owning Lehman paper back in the September 2008. At the time it started a bit of a run on money funds and exacerbated the financial panic. So the SEC, obviously, in many ways across the board does not want to see 2008 repeat, and the run on money funds that was a part of that panic would be one of the issues that the SEC and Washington regulators have been looking at ever since.
Benz: Just to back up, "break the buck" means that the net asset value would actually drop below $1.
Rekenthaler: That's right. Money market funds historically have a fixed asset price of $1 per share. They do not float, that's why they feel like money in part, or cash. The Reserve Primary Fund, because it owned Lehman Brothers commercial paper and Lehman went bankrupt overnight, was forced to mark down its assets to I believe it was $0.98. So, it wasn't substantially less than $1. But it was less. It surprised people. They didn't expect it, and they bailed out of that fund in a hurry and started looking at other funds. As you know in a financial crisis, panic begets panic, and the Reserve Primary Fund and the money market system was a part of that panic.
Benz: So, the SEC has been looking at the industry. There have been a few tightened regulations over the years. The recent set of proposals take a look at a couple of different areas. The one area in the proposal relates to institutional prime money market funds. Let's talk about what they are and how they might be different from the funds that retail investors might hold.
Rekenthaler: I want to take a step back here, too, and set the context. There were proposals that were floated last year for all kinds of mutual funds for every flavor, not just institutional prime. And they did not pass within the SEC. The SEC staff had come up with them and recommended them, but the SEC Commission has voted 3 to 2 against it. So there has been dissension within the SEC. There's also been an enormous amount of political pressure on it. The banking industry has a strong view on this subject. The mutual fund industry has a strong view on this subject. And Congress has a various people with views. So there has been a lot of pressure, and what one might term a bigger solution that was proposed last year was shot down.
The [recent activity] is a retreat and more of a compromised solution where the proposal is to take a segment of the money funds and say, "We'll let those net asset values float, but other money funds we will treat as in the past." So, I look at this as something of a retreat from the strong reforms that were proposed. Now it's a partial reform. And it's a sign the Investment Company Institute, the mutual fund trade organization, is now happy with the proposal, as opposed to previous ones that they were unhappy with.
Benz: So the previous proposal would have required a floating NAV of all money markets?
Rekenthaler: Or a capital buffer. Have the funds set aside capital, as banks have to do, and the argument is, which I think is basically correct, money funds are a type of bank. But unlike a real bank, they don't have to have any capital set aside for losses. So, either have them set aside capital for losses or have their prices float, one or the other, for all funds. And the Investment Company Institute was strongly against that. But they can accept this compromise proposal with the institutional prime funds.
What institutional prime funds mean, the prime fund is a fund that's not a government fund. So, this will be a fund that invests in commercial paper. The thought being funds that invest in commercial paper are more likely to experience a sudden decline because that commercial's entity goes under as opposed to the government, which we certainly hope will not. What I find the most interesting part of the theory is, why institutional? Because the theory is the institutions will do the run on the bank and not the retail investors, that the institutions are quicker to pull the trigger rapidly and have a herding instinct and pull out all their money at once. So, in essence this proposal is saying retail investors are to be trusted, but not institutions.
Benz: John, let's talk about whether retail investors should be satisfied with this compromise. So, in essence the underlying securities in a money market fund that they might own can in fact fluctuate a little bit, but they just wouldn't see that fluctuation?
Rekenthaler: Can we call that a harmless fiction? That is how money funds have historically operated, right? They've always had a fixed price, but these are marketable securities. They are very short; they are very high-quality. But nonetheless because they are marketed securities, they have a price they trade. There is a little bit of movement in their price, and sometimes that fixed price of a $1 per share may not be technically strictly accurate. But the fund company will honor that price and has honored that price. And I would argue, though it's a system that when you look at it from a theoretical perspective it may not all hang together, in practice it really has. Aside from that Reserve Fund, which was a small company and also an institutional fund, for 35 years money funds have served retail investors well. There have been a few cases where money funds have run into trouble to retail investors where they may have had to break the buck, but the sponsoring fund company historically has stepped up and made that fund hold. And I think that will occur in the future.
If you look at any major fund company or a major financial institution that has its reputation on the line, it is not going to stick people with a loss in a money fund. So, I think from a practical perspective, it's really perceived as usual for the retail investor. The rules apply to funds that they don't own unless you have $1 million, the institutional prime funds. I'm comfortable with I think when you look at the evidence that money funds are a good product, assuming that the yield is there. They are a good investment and safe investment for a retail investor. They have been in the past. I don't see why they wouldn't be in the future.
Benz: Certain fund companies have started to show exactly what their NAVs are on a day-to-day basis. I have looked at some of that data. It's kind of like watching paint dry. It's hard to see any fluctuations at all. They tend to be pretty stable.
Rekenthaler: It is. Yeah. I wouldn't recommend that for excitement. It's worth noting fund companies are of two minds on this subject. Some of them believe they'll lose a lot of market share if the prices move because it will destroy the illusion that this is cash or money and will cause people to go buy bank certificates of deposit as an alternate investment. On the other hand, other fund companies would like to see these prices fluctuate like the ones that you cite because now they don't have to step in if the price declines. Right now, as a retail investor, there is an advantage to the fixed price because if the price goes down, it means the fund company is going to step in and absorb that loss since the price isn't expected to go down. So, you could argue in a way that for a retail investor this fiction is actually better for you because the fund company is on the hook.
Benz: If the fund company indeed is going to do the right thing?
Rekenthaler: Well, I don't think it's a question. I don't think they have a choice, but to do the right thing. The Reserve Fund happened to be a very small organization; they couldn't afford to do the right thing. But if you are with any larger company, I don't know whether it's a right thing or wrong thing. You can argue investors maybe should be responsible for losses on their own investments. The reality is I think the company will have to do so to preserve its reputation.
Benz: In addition to the floating net asset values for prime institutional funds, there were some other parts to this proposed list. Let's quickly talk about those.
Rekenthaler: Well there were sort of these secondary alternative proposals of capital buffers for certain kinds of funds that were like what was advanced in 2012. I don't think that we're going to go there, but this is open for comments now from various parties. So, maybe it'll get pushed in that direction. But my guess would be the proposals that we talked about, the floating rate for the prime institution funds will end up being what is adopted because that appears to have broad support. Political support and support from various industries is something that all parties appear to be able to live with.
Benz: John, thank you so much of discussing this part of the mutual fund industry.
Rekenthaler: Absolutely, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.