Now that the global economy appears to be on the road to recovery, investors are gradually beginning to step off the sidelines and take on more risk, as markedly proven by fund flows. Money market fund assets surged to $3.9 trillion in March, but have since fallen back to $3.6 trillion. Meanwhile, investors steadily withdrew $259 billion from equity funds between June 2008 and March, but in the past four months, they have since have moved $50 billion back in.
But it has been those money funds that have kept mutual fund investors appeased in the downturn. Safe investments like cash and money funds did a fantastic job of protecting assets during the recent bear market when the average equity fund lost more than 30%.
Now, however, investment experts predict investors and fund companies will start looking for higher yields soon, if they haven't already.
"Investing in cash has become less satisfying for investors," said Steve Meier, global chief investment officer for cash at State Street Global Advisors. "The second quarter saw a tremendous reduction in risk aversion" as investors began to leave the safety of high-quality, short-term securities in favor of riskier stocks and bonds.
Money market fund yields are skirting near historic lows, but they could still go lower, Meier said. For a few months in late 2008 and early 2009, risk aversion was so great that Treasury bills were trading at negative yields, forcing many firms to waive fees on these funds in order to maintain the $1.00 net asset value (NAV), he said.
These low yields are making it difficult for smaller fund companies that offer money funds as a convenience to their customers, and more than 20 such funds had to provide some level of credit support to their funds in the past year, Meier said.
"How long will these firms be willing and able to subsidize money funds?" asked Steve Schoepke, director of research at Financial Research & Analysis Associates. "Do you subsidize indefinitely? That's not really a business plan. Smaller accounts will be rethinking their use of money funds."
With their low fees, money market funds have never really been a cash cow for companies, and firms must manage a significant amount of assets in order for the funds to really pay off, Schoepke said.
Fidelity, Vanguard, American Funds, JPMorgan Asset Management, Federated Investors and BlackRock/Barclays Global Investors are by far the biggest fish in the money fund pool, controlling approximately 45% of all money fund assets.
At the end of 2008, the top 20 firms held 89% of money fund assets, up from 79% of assets in 2005, Schoepke revealed in a study titled, "Consolidation in the Money Market Mutual Fund Industry: What it Means for Investors." That number could easily top 90% of assets in the next few years, he said.
"The ability of companies to financially support their money market funds does not automatically translate into a willingness to do so," he said.
Continuing pressure on operating costs could force large corporate entities, such as bank-holding and insurance companies, to sell off their money fund units that compete with the company's core business, Schoepke said.
"A lot of people have taken cash management for granted, but all cash isn't equal, and the management of it can be challenging," Meier said. Some companies will find they are better off outsourcing the management of cash to other firms that are more devoted to the space.
The $3.65 trillion money market fund industry has been bleeding assets for months, but even with outflows of $116.5 billion in June, money funds still made up 36% of the approximately $10 trillion in total mutual fund assets, according to the Investment Company Institute.
"A trickle out of the money market space tends to be a gusher in other asset classes," said Peter Crane, president and CEO of Crane Data LLC.
As investors continue to return to better yields from equities and bonds, the money fund industry will continue to see outflows, but the outflows won't be drastic, he said.
Crane said there has been surprisingly little consolidation in the money fund space so far and does not anticipate there will be many shifts. Money fund assets tend to remain quite sticky, and asset levels are more related to mergers and acquisitions, as opposed to investor deposits and withdrawals, he said.
"Money funds are at the mercy of larger agendas," he said.
Crane said companies would be foolish to dump their money fund units, especially after they proved so valuable during the recent bear market.
"The survivors of this bear market were the ones who kept their money market funds," he said. "The biggest winners in the mutual fund game had the broadest exposure in money funds. You've got to have money market funds to survive a bear market. Anybody exiting this space would be a fool."
"It doesn't cost a whole lot to run a money market fund," Crane continued. "The top guys are all managing well over $30 billion," and the average fees of 35 to 40 basis points have barely inched down since 1994, when money funds were a fraction of their current size.
Money funds have a decisive advantage over cash deposits and commercial paper even when Federal interest rates are low like they are currently, Crane said. Rates have been low for months, but they will not stay low for much longer. Crane predicts the Fed will raise interest rates by the end of the year, while Meier and Schoepke think such a move won't happen until sometime in 2010.
"The Fed's rate has never stayed in the same place for two years," Crane said. The last time the Fed raised rates after keeping them at low levels, money market funds lost 10% of their assets, peak to trough. "I think we will see that again," he said.
When the Fed eventually does raise rates, the level at which they increase will depend on the speed of the recovery, Meier said. The trick is to raise interest rates at the same rate at which the economy is improving, so money fund NAVs and yields also rise, while keeping inflation at bay.
The Securities and Exchange Commission is asking for comments on its proposals to tighten Rule 2a-7 governing money market funds-partly to reign in the growing systemic risk that large institutional investors play-and the outcome of their decisions could spur more movement within the money fund space, Schoepke said.
The Investment Company Institute is strongly opposed to one of the proposals to eliminate the stable NAV and has said that such a move would destroy the fund industry and one of its most popular products, but industry leaders don't think the SEC will take that step.
"The floating NAV does not have even a small likelihood of becoming a reality," Crane said. "It will be crucified during the comment period."
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