Are the Money Market Mutual Funds about to become Fundosaurs (def: money market fund dinosaurs). A "White Paper" on money market mutual funds.
Daniel M. Perkins, RIA
Two years ago I sent to the SEC a white paper on the relevance of money market mutual funds considering all the problems the industry experienced after the collapse of the Reserve Primary Money Market Fund in September 2008. At the time I felt one of the problems affecting not only money market mutual funds but also many mutual funds was style drift. Managers were reaching for yield and so they extended their maturity and or went down in credit quality in order to get more yield. What has happened over the ensuing two years that will impact the survival of these money market mutual funds?
In the fall of 2009, the money market mutual fund industry sent a 125-page report to the SEC trying to show that all was right in the world and things should stay about the way they were. This was all code because the industry would fight the real issue of breaking the buck on money market mutual funds. Why was the industry so concerned or perhaps paranoid about breaking the buck? If the money market mutual fund broke the buck the vast majority of money fund assets would go to the banks and the industry with a 45-year history would close down and money market mutual funds would become, as the title of
this white paper, suggests “Fundosaurs.” (Def: mutual fund dinosaurs) In a discussion with Randy Merk of Charles Schwab over two year ago, he said, “The industry will spend whatever it takes to keep the net asset value at a buck. The cost in many respects has been very high.
Paul Volker has been quoted many times about the changes he thinks need to be made in money market funds because he sees a significant amount of financial risk in money funds. With this as a foundation let us look at what other things have had an impact on the viability of the money market mutual fund over the last two years.
On September 15, 2008, the Reserve Fund lost $785 million in Lehman commercial paper. As a result, the directors closed the fund for redemptions and people were stuck. The financial press has not done a very good job in reporting the outcome. It is three years later and the Reserve Management Company no longer manages the fund and a liquidator is trying to settle all the claims against the remaining assets, http://www.ther.com/fundsnews.shtml. The fund still hasn’t made all of the distributions and the likely scenario is that the liabilities will erase any remaining assets. For a fund that was supposed to provide liquidity, three years and counting seems like a long time to wait.
How liquid were the money market funds during the financial crisis? We found out after the fact that the Fed lent over $180 billion to money market mutual funds in order to meet redemption demands. The Fed said, “Over the days prior to the initiation of the program, some money market mutual funds experienced significant demands for redemption by investors. In ordinary circumstances, they would have been able to meet those demands by selling assets. Recently, however, many money markets have become extremely
illiquid, including the asset backed commercial paper (ABCP) markets. This program is intended to help restore liquidity to the asset backed commercial paper (ABCP) markets and thereby to help money funds meet demands for redemption.”
We past the liquidity problem and then we had changes that the SEC implemented when it changed the provisions of 2e7 in Release No. IC-29132; File Nos. S7-11-09, S7-20-09 effective May 10. 2010. These new provisions were designed to improve the credit quality of the investments in money market mutual funds and shorten the duration of the investments. The SEC recognized that there were problems of style drift and the new provisions were designed to address the issue. The question is how are things working out?
In my original white paper I suggested that one of the problems was style drift, reaching for yield. In an article that appeared in the Wall Street Journal July 22, 2011 Mary Pilon and Jon Hilsenrath said. “While the biggest U.S. money funds have minimal direct holdings of Greek government debt, they hold roughly $1 trillion of debt issued by big European banks such as BNP Paribas SA, Barclays PLC and Deutsche Bank AG, according to industry analysts.”
On September 25, 2011 Investment Executive reported; “The rating agency says that U.S. prime money market funds (MMF) further reduced their total exposure to European banks in August. European bank exposure currently represents 42.1% of total MMF holdings within Fitch’s sample, down from 47.2% at the end of July. On a dollar basis, MMF exposure to European banks declined by 8% since the end of July, and is down by 27% since the end of May, it adds.” Why?
The answer is simple; their style drift got exposed in the press. The yield for a Euro CD was substantially higher that CD interest rates in the United States of equal maturity. So here we are three years later and over 40% of money market mutual fund assets are invested in European banks because of higher yields and subject to at least market risk if not credit risk. What would drive money managers to seek higher yields overseas?
Money market funds are approaching three years of at or near zero return. Barron reports every Saturday the returns on US government, general and tax-free money funds. (http://online.barrons.com/public/page/9_0204-trmfy.html) If you go to this web site you will see that US Government money market funds have a national average of 1 basis point average annual yield while the general money market funds have an average of 2 basis points yield and the tax-free return is 1 basis point.
How is it possible, if a fund is going to comply with the new rules of 2a7, to have a rate of return at or close to zero? The SEC in their new 2a7 rules requires funds to publish on the fund web site the shadow returns, but not a shadow net asset value. One of the largest money market mutual funds is the JP Morgan OTBXX which has an unsubsidized 7-Day SEC yield of -1.09% but the true NAV adjusted for negative yield would be .9891. If the funds are actually losing money then how can they show a stable NAV of $1.00?
Randy Merk of Charles Schwab, who served on the committee that wrote the 125-page report, said in a conversation with me in the fall of 2009, “the industry will spend
whatever it takes to hold the buck.” How much is it costing to wave the fees and who is paying? The Bond Buyer said in an article of November of 2010 that, “each basis point of waived fees represents $280 million of lost revenue to money fund managers.” The money market fund industry as a whole will probably waive and pay in excess of $10 billion in 2011. Charles Schwab reported in their third quarter earning report 2011that the fee waivers accounted for $160 million and they fully expected that should interest rates remain at the current level they could lose as much as $180 million in the fourth and subsequent quarters. In the almost three years since the end of 2008 the cost to Charles Schwab to keep their money market mutual fund a $1.00 has been over a billion dollars.
Federated Investors CFO, Tom Donahue comments, "Waivers impacted money market as expected. Full details are on the press release. As we look ahead, we think these waivers could impact fourth quarter by around $26 million in pretax earnings, compared to the $23.2 million in the third quarter 2011.
The Investment Company Institute reported on October 27, 2011 that money market mutual fund assets were $2.634 trillion. If we apply a 40 basis points cost for fees and expenses waived by the managers, then this year that equated to $10.5 billion in lost income and paid expenses by the money market fund managers. Every business day the money market mutual fund industry gives up $40 million, but who pays this incredible amount of money?
The money market fund shareholders, as we have seen, are making in many funds zero or close to zero return and have been for almost 3 years. The Chairman of the Federal Reserve has told the markets that the Fed is on hold for at least 2 more years. Some Fed watchers think it will be longer than three years. If the two more years is accurate then the industry is looking at possibly $21 billion in additional losses.
If, in two years, the Fed starts raising interests rates it may take some time for yields on investments to catch up to the point that the funds can show a positive yield over expenses. If the time line is correct then it will be 5 years that the industry has waived income and paid operating expenses or perhaps as much as $55 billion. The follow up question could be a white paper in itself. Who is paying this $55 billion dollars? The answer to that question depends on the nature of the asset management company. Public companies like, Charles Schwab, and Federated, and others can tell us how much it costs them in waived fees but all the private companies make it more difficult.
I believe that all mutual fund shareholders, regardless of the asset class, share a cost of the waved fees and expenses for money market mutual funds. The overhead to run these money funds is being allocated to other funds. In the case of public companies the company common shareholders bear the burden of reduced earnings per share caused by the waived fees and paid expenses. If this is such a bad deal then why are the fund companies continuing to lose money on this business when they know full well that they will be losing money for the next two to three years?
In a word, fear! The ICI reported on October 27, 2011 that total mutual fund assets, including money market funds, was just over $11 trillion and money market mutual fund assets accounted for almost 24% of total mutual fund assets. They may not be making money today but when the markets change and the savers once again turn into investors it is much easier to convert a cash asset into a stock fund if you hold the cash.
A fear is that the money would leave the money fund and go to the banks and the fund companies might never get the money back. I think the greatest fear the fund companies have is that the SEC may decide, that after careful review of the shadow pricing, that holding the NAV of money funds at $1.00 is not in the best interest of the shareholders. A money market mutual fund using a dollar constant doesn’t demonstrate the potential risk in the investment to investors. The SEC, because of the Reserve Fund problem, has all money market fund prospectuses labeled with the following warning: Not FDIC insured | no bank guarantee | may lose value.
If the SEC were to eliminate the $1.00 NAV it would cause people to rethink where they are investing their money. People don’t seem to realize that there are risks in owning a money market mutual fund and that is why you get a prospectus when you invest. I happen to believe that, should the SEC break the buck, a significant amount of money will move to the banks, S&L’s and credit unions first because these all pay a positive return for some type of deposit account and second they are insured by FDIC up to $250,000. For the life of me I don’t understand why people have not moved more money to the banks over the last few years than has been moved. I have concluded that money fund managers and investors were waiting on the Fed to raise interest rates to bail them out. When the Fed Chairman said to everybody that he is on hold for two years the wind came out of the sails and now managers and investors alike are trying to figure out what to do with this problem.
Bloomberg, in an article on August 26, 2011 titled “U.S. Banks Said to Seek Relief From Regulators as Deposits Swell” said: “Cash held by domestically chartered U.S. banks, which includes Federal Reserve balances, rose to a record $1.02 trillion earlier this month, up 27 percent from the end of July last year. Deposits held by the 25 largest lenders expanded to $4.69 trillion.” The National Information Center reported as of September 30, 2011 that the top 10 banks in the United States controlled about 43% of all deposits and the top 50 banks controlled 83% of the deposits.
The banks are between a rock and a hard place at the moment. Money market mutual funds have been a pain for the banks for at least the last 30 years. There is nothing more they would like to do than to put them out of business, but as was reported above the deposits are growing way beyond the banks ability to lend. CNBC reported on August 4th, 2011 that Bank of New York Mellon was going to start charging depositors over $50 million 13.5 basis points fee to hold their deposit. As much as the banks would like to put the money funds out of business they would have serious problems in handling the money.
A significant influx of deposits would put downward pressure on deposit interest rates at major banks. According to Bankrate.com the national average for a jumbo money market account at a bank is 36 basis points annualized as of November 1, 2011. If the banks can’t loan it out faster than it is coming in then any significant increase would bring down deposit interest rates as the banks would not be in a position to earn a spread. Perhaps some in the money market fund industry will say that breaking the buck will just result in lower and lower yield so that in short order both the funds and the banks will be paying zero return so why scare the public by breaking the buck.
It is time to focus on the public and why they are keeping money by the trillions in money funds earning zero. As a Registered Investment Advisor I hold meetings to talk with people about the markets and what they should be doing with their money in order to reach their goals. In the fall of 2010 I held a meeting that was over subscribed with people looking for answers. I asked the group this question, “How many of you have money in a money market mutual fund? Almost every hand went up so I asked the next question, “How much are you earning on your money market fund? Virtually everybody in the room knew that they were earning zero return on their money. The last question was, “Why?” The majority of the people answered, “it is better than losing money.” If the NAV of money market mutual funds were allowed to float reflecting the realities of the market people may change their minds about money in money market mutual funds. I have no doubt that even if the SEC were to change the NAV to a floating NAV millions of Americans will stay right where they are. When we explored some of the alternative like T-Bills they wanted to know if they were safe. I explained that if you own a US Government money market mutual fund the fund already owns T-Bills. If the T-Bills are paying a positive return and the government money fund is paying zero wouldn’t you be better off owning the T-bills outright? They answered yes to that question. Then they wanted to know if they needed money could they get at it with T-Bill ownership. It finally dawned on them to ask the question if T-Bills pay a positive return then why are our funds paying zero? The answer to their question is fees and expenses. All of the income earned is spent to pay the management fee and operating expenses first and then if there is anything left over the shareholder gets paid.
This brings us to full circle on why we had at one time this past summer over 53% of money market fund assets in European bank CD’s. The more yield you bring in the higher the cash flow. The more cash flow the less the management companies have to pay out of their pockets. Even now, as was pointed out above, 43% of money market assets are still invested in European Bank CDs. The Federal Reserve H15 report publishes daily the various interest rates for different assets. In the November 1, 2011 report it showed that the 90-day US CD was yielding 36 basis points. On the other hand the Euro CD for the same maturity was yielding 49 basis points or 33% more yield. If a money market fund was waiving its fee and paying expenses then the difference of 13 basis points in the yield could help offset some of the out of pocket expenses being paid by the fund management company.
The fund shareholder would see no difference in yield but they certainly had a big difference in credit risk exposure. With 43% of all money fund assets currently in Euro
CDs could we be setting, better yet, are the fund managers setting us up for a problem again with style drift, if the banks have to take a significant amount of write downs on sovereign debt? I have to ask, if the changes in the rules 2a7 for money market mutual funds was to make sure the funds were more liquid and have less credit risk, then how is that working out with 43% of assets exposed to European banks? The shareholder can’t see the problem when he or she looks at the NAV of $1.00. The investor couldn’t see the risk in the Reserve Fund when it had $785 million of Lehman Brothers commercial paper that in a matter of a day was worthless. Money funds are publishing their top ten holdings on the fund web sites as part of enhanced disclosure but you would be hard pressed to figure out under the reporting requirements what percentage of a fund assets are in European banks.
If the SEC wants shareholders to know that they have risk in owning money market mutual funds then how does a $1.00 NAV help them understand the risk? The SEC requires money funds to post the yield adjusted for the fees and expenses waived by the management company. In trying to find this information you have to drill down at least 3 levels to find it.
If an investment has little or no chance of making a positive return then should it be considered a failed investment? Vanguard, in the prospectus for their Prime Money Fund, states as its investment objective: Vanguard Prime Money Market Fund seeks to provide current income while maintaining liquidity and a stable share price of $1.
The prospectus goes on to say:
Who should invest?
Investors seeking interest income and a stable share price. · Investors seeking liquidity (the ability to convert assets into cash).
You could look at any money market mutual fund prospectus and find similar language. If the fund has not lived up to its investment objective for three years and has every possibility of not living up to is objective in the next two to three years then how can it be a viable investment--just because it has a arbitrary $1.00 NAV? If the fund manager is paying the expenses of the money fund out of revenue received from other funds they manage then the fund is not viable. Having a $1 NAV doesn’t make the fund a viable investment. So to make it fair to the investor the prospectus need to be changed in both the investment objective and suitability. New language needs to be added to the prospectus that says the manager is unable to determine at what time in the future the fund will pay income to the shareholder.
The suitability section needs to be changed to say that investors seeking income should be advised that an investment in this fund might not be suitable. The manager is unable to ascertain when the fund could pay interest income.
Perhaps some of the money market mutual funds are aware of the provisions I have just spoken about and that is why some funds have an annualized return of 1 basis point. They can say that they are meeting their investment objective. However, if the income is
insufficient to cover the expenses then the 1 basis point is not really earned investment income but an arbitrary amount paid by the fund manager. No money market mutual fund that is paying 1 basis point or any amount of basis points is earning investment income but is, by the SEC’s own terms, subsidized by other non-investment income from the manager.
As was pointed out above, Barron’s on line publishes weekly all the returns for money market mutual funds. (http://online.barrons.com/public/page/moneymarketfunds-taxable-S.htmlds) Through the link provided you will see the letter K after virtually every money market mutual fund. The K symbol indicates that All or a portion of a fund's expenses are currently being waived or reimbursed by the asset management company.
If the fund cannot produce a return on its own and the prospects are that it may be several years out before it can then the way the distribution is paid is in fact a profit-sharing arrangement with the management company and is prohibited under the 1934 Act. In the SEC report Study on Investment Advisers and Broker-Dealers released in January 2011 on page iii, it states:” Investment Advisers: An investment adviser is a fiduciary whose duty is to serve the best interests of its clients, including an obligation not to subordinate clients’ interests to its own. Included in the fiduciary standard are the duties of loyalty and care. An adviser that has a material conflict of interest must either eliminate that conflict or fully disclose to its clients all material facts relating to the conflict.”
My concern is that the advisor makes the decision of how to invest to minimize its out of pocket expenses, how is this not a conflict of interest? If that is the case and we have already seen how some manager have decided to invest the money buy taking the risk of Euro CD’s because of the demonstrated yield advantage then these decisions are in fact conflicts of interests. Sharing of fee income by a client is not permitted and a manager that pays a yield based on other income is sharing other fees with the client.
A money market mutual fund is not registered as a hedge fund. In the hedge fund structure the manager shares in the results of the investment. If money market mutual funds are going to continue to operate they way they have then they should be re-registered as hedge funds.
While I’m advocating the change of money market funds to hedge funds structure Paul Volker, former Chairman of the Federal Reserve feels differently. He said in a recent speech that he is “advocating for regulatory control over the money-market mutual fund industry and believes the government should stop financing mortgages.”
Volcker said in a recent speech “that money market funds have exacerbated stress in the financial markets because they pulled back on short-term lending to European banks.”
“If money-market funds are to continue providing significant funding to regulated banks, they should be subject to capital requirements, deposit insurance protection and stronger oversight of their investments,” Volcker said.
"The time has clearly come to harness money market funds in a manner that recognizes both their structural importance in diverting funds from regulated banks and their destabilizing potential."
I’m not sure that I agree with everything he says but the point about impacting the foreign banks I have already addressed. The problem as expressed in my 2009 white paper was the problem of style drift, reaching for yield or return. The point that Mr. Volcker didn’t make is that US managers were driving foreign banks to pay more yield to attract deposits. When they were found to have 53% of assets in foreign banks they got nervous because of headline risk and began reducing their exposure.
This rotation out of Euro banks caused the money to come back to the United States and in turn put downward pressure on short-term interest rates. As the volatility of the EURO problems continued the demand for short-term US debt actually drove 90-day T-Bill interest rates to negative returns on October 31 and November 1, 2011.
Investors who hold US Government money market funds are suffering from two problems. First, the restrictions placed on money funds as to how they are to invest the money leaves them no room to operate and second, market rates are near zero or lower and if the Fed is on hold for two years they can never make money for investors or partners.
Investors who are waiting for yields to return say that zero return is better than losing money. If you invested $100 in a US government money fund at the end of 2008 you had a NAV of $1.00 and a yield of zero. By the middle of 2011 you would still have had a NAV of $1, a yield of zero but your money on an inflation-adjusted basis was worth $95. In his question and answer session of November 2, Mr. Bernanke said that inflation was about 2% per year since the end of the recession. If we are in for zero return for two to three more years then inflation will erode the purchasing power another 4% to 6%. If the investment is not viable then what role do the independent board members have to the shareholders.
I find it interesting that by example, the investors in the Oppenheimer Money Market Fund earned close to zero return and the outside directors earned $280,000 a year. If you look closely, many of the outside directors of this fund sit on the boards of other funds receiving similar compensation. If the outside director is there to protect the shareholder then why are they not raising the question as to why are we continuing to run this fund that provides no economic benefit to our shareholders and collecting our board fee?
Some managers and outside directors have decided to close their funds. Recently Pay Pal said in a press release “As of last week, the fund held $471 million and had returned 0.04% to investors so far this year, reports SmartMoney. A PayPal rep told SmartMoney, “market conditions, financial advantages of the money market fund have diminished” for its merchants. In the past, the fund was seeing around 5 percent in returns. But more recently, the fund earned around 0.15% in returns. The economic value was no longer there for the investors and they closed the fund.
One could disagree with the way they did it but they said it doesn’t work, lets close it down and send the money back and let the investors see if they can find better options. Must an investor make the decision or does the board have some responsibility? I think so. How long will the SEC wait to put in place some time frame that money funds have to close? I realize that forced closing is difficult to order. But, if money market funds don’t work, are fund managers playing a dangerous game if investing to minimize the amount of the fees and expenses they have to pay puts shareholders at risk. Take away the $1.00 NAV and allow people to see what the real return is for their investment and then they can decide if they want to stay with the fund or look for alternatives.
There is one area of money market investing that has received no attention. I have already talked about the fact that money market mutual funds are paying at or near zero return. I have spent a good deal of time talking about waiving the fees and paying the expenses in order to produce a flat return. What the SEC or state regulators have not addressed is the mounting losses in money market funds inside a separate account investment like a variable annuity. While the mutual fund managers may have waived the fees the insurance companies charge mortality, expense, and administrative fees that have not been waived. I use Nationwide as an example but I could take you to every mutual fund variable annuity and show you the same information. If you go to http://www.nationwide.com/destination-c-annuity.jsp you will find a section called performance PDF. In that link you will find that the current yield on the money market fund is -1.60%.
Further down the spread sheet you will find the average annual return for the past 3 years is -1.48% per year. This investment is supposed to be a supplemental retirement program. Whatever amount you have in the money market option you lost almost 1.5% per year for the last 3 years and if the Fed stays on hold you are most likely looking at an additional 3% decline in account value. The insurance company collects its M&E charge by selling assets in the account. The NAV of the separate account money fund has declined every month for the last 3 years even though the money fund managers have waived their fees and they are paying most of the operating expenses. It seems to me that a new warning needs to be on the separate account prospectuses that says: “The money fund option offered in the investment has not produced a positive return for three years and the manager is unable to determine when this investment option will produce a positive return. You may well see a decline in the net asset value of your investment.
Can investors find better options for their money regardless if it is in a stand-alone fund or part of an annuity or life insurance investment? First, it depends on the need for the money in a money market mutual fund. If it were an account that is used to pay bills then perhaps a bank money market checking would be better. This account pays a positive return and you have check writing privileges. If on the other hand money in a money market account is just a parking place for money that investors don’t need then there are many alternatives. If the NAV of the money market fund truly reflects the investment potential then investors can look at the money fund in a list of alternatives. In the case of the separate account investment you need to look at other options for this money to work
its magic best by growing. Money market fund options are almost certain to lose money so your money in a variable annuity money fund will never grow, at least for the foreseeable future.
Money in a bank money market account currently is an alternative that pays a positive yield and is FDIC insured up to $250,000. If money in a money market fund is just a parking place then extending maturity in US Governments can increase yields and using a ladder approach can reduce duration risk.
The real issue is that the $1.00 NAV has given investors a false sense of security. By pricing the NAV at the market like every other mutual fund, then money market fund investors will have to make decisions as to how much risk they are willing to take. No doubt many investors will stay with their money market fund while others will look for alternatives. Like many things in life we don’t like to make decisions if we don’t have to and taking away the $1.00 NAV will force decisions to be made. Clearly the Fed is trying to force us to make decisions we don’t want to make.
The Financial Post reports that “Operation Twist” — the purchase of long-term government bonds at the expense of short-dated Treasury debt by the Federal Reserve — may be the next policy tool for the ailing U.S. economy. The goal is to effectively “twist” the yield curve by keeping near-term rates unchanged and lowering long-term interest rates, thereby encouraging economic activity.
Ideally, short-term rates will remain strongly anchored by the Fed’s recent indication that it will keep policy rates near zero for at least two years. Long rates, meanwhile, would fall in response to the central bank’s purchases.
The Chairman of the Federal Reserve is trying to force all investors into taking more risk. He feels that if he can make interest rates so low, near zero, investors will be forced to take risk with what he hopes as the outcome will be economic recovery, more jobs and prosperity. If the playing field is in fact leveled then investors no matter how much they don’t like to make investment decisions can make better decisions.
Money market mutual funds served a useful purpose for many decades but their time has past, like the dinosaurs. The volatility in the world markets has made it more difficult to make decisions about investing ones money. Having as much information as possible is very important and one of the most important pieces of information is an understanding of the risk the investor is taking. I seriously question the viability of money market mutual funds. People will need the chance to earn a positive return at least for college and most important, retirement. I have no doubt that money market funds will be around for many years to come, but they will be here because they are fair, open and compete with other options. The SEC is faced with a difficult challenge, but one that should put the investor at the forefront of what they do. It must change the disclosure, the registration, and the risk associated with money market mutual funds to protect investors.
Contact information:
Daniel M. Perkins, Chairman
Daniel M. Perkins, RIA, LLC
1066 Sand Castle Rd
Sanibel FL 33957
Phone 973.966.9500 e-mail www.liquidityreserve.com blog: www.moneyinmot.blogspot.com
