Money Matters: Money market funds and return-free risk

David Peartree, The Daily Record Newswire

“Return-free risk” is a turnabout of the more appealing concept of risk-free return.

The phrase was given currency by James Grant, the editor of Grant’s Interest Rate Observer, some years ago when voicing his concern that U.S. Treasuries might turn out to be return-free instead of risk-free.

Grant’s original concern with Treasuries is edging closer to reality and the phrase now aptly describes the current state of money market funds. Money market funds are not risk-free and they currently offer no returns. The average yield on money market funds is well under .05 percent, a return that is for all practical purposes zero and a dramatic decrease from the 4.9 percent average rate in 2007.

U.S. money market funds are a $2.6 trillion slice of the financial markets that provides much of the short-term financing for corporations and governments.

They are a major source of funding for banks and therein lies the concern of regulators.

According to a report released earlier this year by the Federal Reserve Bank of New York, large global banks increasingly rely on money market funds for funding. The funds gather deposits from individual and institutional investors and lend the money to banks. In 2012, money market funds financed 43 percent of U.S. financial commercial paper and 29 percent of certificates of deposit.

Four years after the financial crisis first unfolded, the SEC and other regulators remain concerned that money market funds pose a systemic risk to the financial system. They are prone to a run during a financial crisis if investors begin to question the stability or liquidity of a fund based on negative news about the fund sponsor or, more likely, the banks to whom the fund has loaned money.

In 2008, the Reserve Primary Fund, one of the oldest money market funds, “broke-the-buck,” meaning it failed to maintain a $1 per share value, because of its exposure to Lehman Brothers debt. By way of reassuring investors not to worry, it was widely reported that this was only the second time in 25 years that a fund had broke-the-buck.

While true, a 2012 working paper by the Federal Reserve Bank of Boston reports that losses were actually more widespread than supposed from 2007 through 2011. Out of 341 prime money funds reviewed, the report concludes that 21 would have broken-the-buck but for financial support provided by the fund sponsor to cover credit losses.

The SEC has attempted over the past several years to reform money market funds by proposing a floating asset value rather than a fixed share price and by proposing tighter capital requirements for banks. The aim was to protect against a run of redemptions.

These proposals failed but the SEC is not giving up. The most recent proposal focuses on “prime” money market funds that invest in short-term corporate debt as opposed to government debt. The proposal would require money market funds used by institutional investors to report a floating share price, as do other mutual funds.

If adopted, this rule won’t directly affect individual investors, but it should serve to remind them to be vigilant against risk. Money market funds are widely used by individual investors in brokerage accounts and are assumed by many to be risk free.

Money market funds are not entirely fungible commodities where one is as good as the next. The SEC may set broad parameters for credit quality, maturity and diversification, but funds still can differ in ways that matter to investors.

First, expense ratios vary and a few funds that have refused to waive management fees actually are showing a negative nominal return, a guaranteed loss, never mind that virtually all funds are showing a negative return on an inflation adjusted basis.

Second, fund sponsors may differ in their ability or willingness to stand behind their funds should they threaten to break-the-buck and cause a run against the fund. The Boston Fed study found 78 instances of funds receiving some form of direct support from their sponsor. To dismiss the risk entirely investors would have to assume that fund sponsors would back them up again during another financial crisis.

Third, money market funds are actively managed mutual funds. Investors rely on managers to perform solid credit analysis and make good decisions about what to buy or what not to buy.

For example, leading up to the financial crisis, some managers were willing to hold structured investment vehicles and asset-backed commercial paper, both of which turned out to be problematic. Others wouldn’t touch it.

Even today, some managers are willing to invest with European banks. Others have eliminated all exposure to European banks, deeming it to be a risk not worth the marginal increase in yield.

Money market funds are not FDIC insured and they can lose money. They carry risk but presently offer no compensation. Many money market investors are either oblivious to the risk or they are assuming that fund sponsors will absorb any losses because some have in the past.

Review your options

1. Find out if you have access to an FDIC-insured sweep account in lieu of a money market fund.

2. If not, consider a Treasury or government money fund as opposed to a prime money fund.

3. If your options are limited to a prime money market, examine it closely and think carefully about how much should be parked in the money market. Fiduciaries, in particular, need to be vigilant on this. This includes
trustees and employers sponsoring retirement plans.

The extent of the risk may be a matter of debate, but even if the risk is low the frustrating reality is that investors are not being compensated to take any risk. It is naïve to assume that fund sponsors will always be willing and able to protect investors against losses. Informed investors will protect themselves.

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David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.