The upheaval in the money market fund sector during the past 18 months has prompted a number of proposed regulatory changes in the United States, United Kingdom and Europe. Although designed to enhance the safety and transparency of these investments, the proposed changes also will likely cause institutional investors to rethink their approach to investing in money market funds.

Money market funds have long been considered a bastion of safety, even during times of financial crisis. That changed last September, however, when the net asset value (NAV) of the Reserve Primary Fund fell below $1 per share and the fund couldn't meet redemption requests.

“The mere fact that a fund 'broke the buck' was so unprecedented and such a shock,” says Peter Crane, president and publisher, Crane Data LLC. In retrospect, the problems besetting the Reserve fund shouldn't have been a surprise, Crane adds. Although money market funds revealed their vulnerability for the first time in a long time, they remained stronger than many asset classes. “The fact that only one money market fund broke the buck is testament to the durability of the funds themselves and the regulatory structure,” Crane says.

To be sure, if the U.S. Department of the Treasury hadn't stepped in with its Temporary Guarantee Program for Money Market Funds, or the Federal Reserve Board with its Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), a full scale panic was a real possibility. The AMLF, for instance, allowed money market funds to borrow against their asset-backed commercial paper to meet redemptions. That instilled confidence in investors and helped avert a run.

Still, the events of last fall were a reminder that money market funds typically are not guaranteed and that investors can lose money. “Investors need to have a good understanding of what they are investing in,” says David Rothon, global fixed-income strategist at Northern Trust, London.

Changes on the Horizon

Money market funds represent a large and critical segment of the financial world. According to Crane Data, money market fund assets have grown to about $3.6 trillion at the end of 2009 from about $1.8 trillion at the beginning of this decade.

“The money market sector has proven to be important to a well-functioning financial system,” says Peter Yi, director of money markets at Northern Trust. “It's the grease that allows the wheels of financial system to turn. That's why the credit freeze within this sector was one catalyst to a broader credit crunch,” he notes.

In the United States, Rule 2a-7 of the Investment Company Act of 1940 governs money market funds. The rule was amended in the 1990s and worked effectively for about a decade, but faltered under the recent market turmoil, says Bradford Adams, senior product manager, Northern Trust. In fact, the Reserve Primary Fund actually was operating within 2a-7 when it ran into trouble. “That highlighted the fact that 2a-7 was inadequate for the challenges money market funds faced,” Adams says.

To remedy this, the U.S. Securities and Exchange Commission (SEC) is considering changes to the regulations, and has received proposals from several groups, including the Investment Company Institute (ICI).

The main objective of any regulatory changes would be to manage systemic risk. Currently, about 40 million investors hold registered money market products. When significant redemptions occur, the liquidity in the system is unable to accommodate them, which means sales take place into a distressed market. The proposals are intended to mitigate that.

“In general, we're looking at the proposals with optimism,” Yi says. “They're ultimately good for the industry and will strengthen it.”

Money market funds represent a large and critical segment of the financial world. According to Crane Data, money market fund assets have grown to about $3.6 trillion at the end of 2009 from about $1.8 trillion at the beginning of this decade.

A Closer Look at the Proposals

Several of the proposed changes concern the maturities of the securities within money market funds. One would reduce the weighted average maturity (WAM) of a fund's portfolio from 90 to 60 days. By convention, WAM measures a note with a floating rate to the date of the next interest-rate reset. So, a floating-rate note whose interest rate changes each month is considered to have a WAM of one month, not the time to the final maturity, which could be as much as a year longer.

This convention is an accident of history, Adams says. When the money market fund sector exploded in the 1970s and 1980s, the primary risk was interest-rate risk because rates were rising. That's changed, and regulators today are more concerned with funds' exposures to securities that will be held for longer periods of time, which increases risk.

Another proposal would cap the weighted average life maturity (WALM) of a portfolio at 120 days; no current regulation limits this. The WALM indicates when a security becomes liquid and pays off. This change would limit funds' ability to invest in long-term floating-rate securities.

Several other proposals focus on liquidity, Adams notes. One requires institutional money market funds to maintain at least 10% of their holdings in securities that mature within one day and 30% in securities that mature within one week. The current version of Rule 2a-7 contains no liquidity requirements.

The ICI is proposing a slightly different version of this change. The group suggests that funds keep 5% of their portfolio in securities that mature within one day and 20% in securities with maturities of up to a week.

Either of these changes would slightly shorten most funds' overall maturities, Crane says. They also might prompt fund managers to focus more on securities that are easily sellable.

Another potential change concerns what are sometimes referred to as “second-tier securities,” or securities rated A2/P2 by Moody's. Currently, under Rule 2a-7, funds can invest up to 5% of their assets in these securities. Under the proposed changes, money market funds would be restricted to only A1/P1, or the highest quality, securities.

This proposal has a good chance of moving forward, Adams says. “It's important to note, however, that such a change wouldn't have prevented the Reserve Primary Fund from breaking the buck. Lehman was an A-rated issuer until the day it filed for bankruptcy,” Adams says. “Allowing funds to invest in A2/P2 securities enables them to diversify away from financial sector issuers, which account for more than half of A1/P1 securities. An argument can be made for continuing to allow A2/P2 securities in money market funds because it tends to help diversification more than it lowers credit quality,” he adds.

The Debate Continues

Several of the proposals have generated more controversy. One proposal would allow funds to suspend redemptions if their asset values fell below 0.995; that is, if they broke the buck. “Some funds outside the United States already allow this,” says Steve Everett, director, balance sheet and operating assets, Northern Trust. “Some industry experts question whether funds actually can withhold money from investors, even though doing so limits the likelihood of selling into a declining market,” he notes.

Another proposal that's generated controversy is the recommendation to move from fixed to floating share prices. “There's an intellectual appeal to a variable net asset value,” Adams says. “It's difficult to create a fund that always remains at a $1 per-share price without severely restricting investment choices. The pressure to continue operating at $1 per share, even when liquidity was poor and security valuations were under duress, contributed to the stress that money market funds faced during the past year.”

However, this change would create a host of other concerns. As a starting point, money market funds currently are classified as cash in most companies' balance sheets, Everett says. If a move to a floating NAV is enacted, they would have to be classified as short-term investments. In addition, such a shift would create gains and losses on every trade, creating a tremendous amount of accounting work. “Money market funds are used by investors who trade frequently. Every day, cash flows in and out of the account,” Adams explains. “Daily gains and losses would have to be recorded, each of which could have tax implications for the investor.”

It's unlikely that this proposal will make it through, as most people think the system works well as it is. Almost all of the comment letters received on the SEC website regarding the idea were opposed to it, Crane says. “No support has materialized for this.”

Investors also should review the maturities of the investments in the fund. The shorter the maturities, the greater the ability of the fund to accommodate redemptions.

“It's widely believed that if money market funds moved to a variable NAV, they would begin to look like ultra-short bond funds,” Yi adds. “This could potentially introduce more volatility to a sector that has always been considered a safe ground for principal preservation.”

Some changes, however, likely will move forward, in part because regulators want to take action. In addition, some updating of money market fund regulation is in order, given that the current regulations are a decade or so old. The SEC has indicated that it would like to have the proposals out by the end of the year, although that could roll into 2010, Crane says.

Yi notes Northern Trust already operates within this framework, focusing first on principal preservation, then liquidity and then yield while also emphasizing credit research and risk management. “Where we will see real benefits from these proposals is by continuing to be a leader within a stronger and more stable industry,” he says.

Steps Investors Can Take

Going forward, investors will want to consider several aspects of a money market fund before investing in it. First, assess the strength of the fund organization, along with its investment process and governance. “People may complain about yield, but they want a solid brand and provider,” Crane says.

To determine this, investors need to focus on the process a company uses to evaluate investments and assess risk. “Until recently, some investors paid little attention to this, treating money market funds like commodities with a sole focus on yield,” Everett says. “Higher rates usually indicate a greater level of risk. It's important that investors understand that yield is a good thing, but it also can be a red flag,” he adds.

Investors also might want to consider the level of resources dedicated to credit analysis, he says. Someone other than the portfolio manager should assemble the universe of securities from which the portfolio manager chooses, thus separating credit and investment decisions. “This helps to prevent a portfolio manager from boosting return simply by selecting a lower-quality security with a higher yield,” Everett explains. “Especially for cash, where you want safety, you need good governance.”

The size and composition of the fund also deserves attention. Larger funds, for example, often offer more investor and issuer diversification, so a single investor or holding will have less of an impact on fund management, Yi notes. Investors also should review the maturities of the investments in the fund. “The shorter the maturities, the greater the ability of the fund to accommodate redemptions,” Yi adds.

“Investors also should verify that the fund has the technical tools to readily evaluate its holdings and risks to make informed decisions. Its systems should provide frequent and robust reports,” Yi says. “In addition, a fund should be able to adopt any proposals that are enacted without wavering in its overall investment philosophy and process,” he adds. “The fund family should have the resources to support more stringent reporting requirements that promote greater transparency and disclosures.”

The money market fund also should be a core element of the parent firm's business, Everett says. In the past, some money fund parents have simply wound down funds that ran into trouble, rather than provide support. Similarly, strong parent companies also are key, as they are more likely to have the resources to support the fund if necessary.

Changing Perspectives

Institutional investors might want to re-evaluate their approach to their cash portfolios, Adams notes. For example, an investor might want to segment the cash portfolio, identifying the portion that needs to stay very liquid versus the amount that can be invested for longer periods. “There will be an array of products across the risk spectrum that provides investors some liquidity and return,” Adams says.

To determine which will provide the best fit, investors will need a solid understanding of the securities, Rothon adds. “There's no substitute for doing it yourself. You want to lift the bonnet and understand where the risks lie.”

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