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Rekenthaler Report

The New Rules for Money Market Funds

Yes, they do affect retail funds.

Suddenly, Six Years Later...
The SEC this week ratified new rules for money market funds (869 pages!). Since September 2008, when Reserve Primary Fund sparked a panic by "breaking the buck" when its Lehman notes plunged in value, the SEC has sought changes that would prevent such a calamity from occurring in the future. The delivery was a laborious, politically charged process. The mutual fund industry liked money market funds just fine the way they were, banks wanted them gutted, and SEC staffers and politicians were caught in the middle. It took many iterations to arrive at yesterday's barely acceptable compromise, which passed by the minimum margin of 3 to 2.

As the SEC did not publish the new rules until after they were ratified, media coverage has been somewhat muddy. Several reports seem to suggest, as does the SEC's press release, that the rules apply only to institutional funds. Not so--the most notable modification, requiring some money funds to float their net asset values rather than fix the price at a constant $1.00, is indeed for institutional funds only. But provisions for liquidity fees and redemption gates apply to all funds, both institutional and retail.

For Institutional Funds Only

Floating Net Asset Value
Fixing a money market fund's NAV encourages investors to shoot first and ask questions later. That is, if a shareholder becomes worried that a money fund has invested poorly, and might possess notes that it subsequently will mark down, then the shareholder would be wise to sell immediately. Those who get out early will be paid at the current, full price of $1.00 per share; those who wait will receive only the marked-down amount.

That said, floating the NAV cannot fully achieve the SEC's ultimate goal of eliminating runs on the money-fund bank. Investors will no longer have sticky NAV prices to encourage them to pull the trigger, but they will have plenty of other incentives for them to flee rumored funds. Those funds might have other troubled assets, where the problems are not yet reflected in the notes' prices. Their portfolio managers may be incompetent. The funds might be forced by redemptions to sell at distress. There are many reasons investors could flee a money fund.

The decision to require institutional money funds--but not retail funds--to float their NAVs does not appear to have been made on solely investment grounds. The investment rationale is that institutions cause more havoc than retail investors because they are quicker to react to news and because they withdraw their assets in larger chunks. That argument is correct, but it doesn't change the fact that retail investors are also capable of mass redemptions and could also be tamed (if not prevented) by floating NAVs.

Apparently, the mutual fund industry wanted the status quo, banks wanted floating NAVs for all money funds, and the SEC decided to split the difference.

NAVs Computed at 4 Decimal Points
The floating NAVs will be computed to 4 decimal places for funds that have current values of $1 per share. Thus, a fund with an NAV of exactly $1 would be priced at $1.0000. The number of digits remains stable for funds that price at different dollar amounts, so that a fund with an NAV of $10 would show a price of $10.000, and one with an NAV of $100 would show a price of $100.00.

It's not clear what benefit accrues from this rule change since, as one SEC commissioner pointed out, the apparent increase in accuracy is largely spurious. Many money market holdings do not price daily and, therefore, are valued by guesswork. (More politely, the securities are said to be "priced on a matrix.") Adding an extra digit to guesswork does not improve guesswork. That said, the change shouldn't cause any real damage, aside from the one-time cost of updating operational systems.

For Retail and Institutional Funds

Required Liquidity Fees
If a money-fund's holding can be easily and readily converted to true cash, the SEC designates that holding as being either a "daily liquid" or "weekly liquid" asset. Should a fund run low on these liquid securities, such that its weekly liquid assets are calculated to be less than 10% of its total assets, then under the new rules the fund must impose a liquidity fee of 1% on redemption requests.

Effectively, those redeeming will receive 99 cents on the dollar, with the remaining penny remaining in the fund as a payment to existing shareholders. A fund may escape this provision only if its board of directors, including a majority of independent directors, overrides the automatic imposition of the fee.

Optional Liquidity Fees
If a fund's weekly liquid assets are calculated to be less than 30% of its total assets, then that fund may impose an optional liquidity fee. The optional fee, for reasons that remain unclear, would be 2%--double that of the required liquidity fee when the fund breaches the 10% liquidity threshold. Once again, this fee must be supported by the fund's board of directors, including a majority of its independent directors.

Optional Redemption Gates
With funds that have less than 30% in weekly liquid assets, fund boards (including, you guessed it, the majority of independent directors) may also vote for the stronger measure of shutting down redemptions altogether. Such gates, as they are called, can be imposed for no more than 10 days within a given 90-day period. When activated, though, they have the effect of completely cutting off all transfers, so that shareholders wishing to access their money funds for any reason are shut down until the gate is lifted.

Summary
The fear of the event outweighed the event itself. These changes are modest.

Floating the NAV may complicate an institution's accounting or tax situation, thereby pushing it toward other cash options, but it doesn't alter a money fund's basic investment characteristics. Neither does calculating an NAV with more decimals, imposing liquidity fees, or creating a redemption gate. The latter two items will no doubt prove irksome when implemented, but they are unlikely to be so common as to actively discourage money-fund investors.

In short, money funds' future looks much the same today as it did a week ago. The funds are currently unattractive to both investors and their sponsoring fund companies (which often find themselves rebating management fees to support the funds' meager yields) because short-term interest rates are low. When rates rise, and thereby boost money fund yields, the new legislation is unlikely to stand in the way of sales. Unfortunately, it also will not do more than slow future market panics.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.