Investors seeking safety and stability have recently been moving massive amounts of their assets into money market mutual funds, causing the funds to swell to nearly $4 trillion and making them the single largest mutual fund asset class, according to the Investment Company Institute.
Despite their growing popularity, there are many problems with these funds that need to be resolved. A new report by the ICI's Money Market Working Group, released Tuesday, addresses these concerns and offers recommendations that will improve transparency, stability and investor confidence.
"We believe our recommendations respond directly to weaknesses in current money market fund regulation, identify additional reforms that will improve the safety and oversight of money market funds, and will position responsible government agencies to oversee the orderly functioning of the money market more effectively," said John Brennan, chairman of The Vanguard Group and chairman of the working group. "We strongly believe that taken as a whole, these recommendations will greatly increase the resiliency of money market funds to the benefit of both investors and markets."
Until about a year ago, most investors kept a small portion of their assets in money funds due to their small but stable returns. Stability is very appealing now that everything else is down 30% or more, but having all that cash on the sidelines is creating new problems.
Two areas where money funds are most vulnerable are their ability to maintain a stable $1.00 net asset value per share, and their ability to remain liquid during periods of mass redemptions.
After the Reserve Primary Fund "broke the buck" last September due to $785 million worth of exposure to Lehman Brothers Holdings, institutional money fund investors panicked and tried to get their money back, withdrawing approximately $210 billion in two days. This panic forced another institutional fund to suspend redemptions and caused the Treasury Department to step in and temporarily guarantee all money funds.
The Money Fund Working Group's 228-page report, four months in the making, was unanimously approved by the ICI on Tuesday and sent to the Securities and Exchange Commission for consideration.
Among the working group's recommendations: All money market funds should impose daily and weekly minimum liquidity requirements and require regular stress testing of their portfolios. Money funds would have up to five days to honor redemptions or purchases; would hold a cash balance of between 5% and 20% that could comprise Treasuries and other securities that can be redeemed in seven days or less and have a 75-day average weighted maturity of holdings rather than 90. They would also have to disclose shareholder classes so that investors would know if there were large institutional shareholders whose actions could severely impact the fund, and disclose holdings monthly.
Money funds should raise their credit quality standards, select only top-rated securities and avoid riskier, second-tier securities, as well as take steps to address client risk to ensure the fund management understands the risk of having a concentrated client base, the report said.
"We have urged its voluntary implementation by all money market funds," said Paul Schott Stevens, ICI president and CEO. "We expect substantial implementation can be achieved prior to September."
Stevens also noted that the Treasury's temporary guarantee is set to expire in April but the ICI has asked Treasury to extend the deadline to Sept. 18.
According to the report, money funds should enhance governmental oversight by developing a nonpublic reporting regime for institutional investors which will allow the SEC to monitor "higher-than-peer performance," to make sure some funds aren't invested in riskier securities.
"Yields shouldn't vary that much" on money market funds, Brennan said. "We recommend the SEC monitor outliers from a yield standpoint. They should engage with outlying funds, as well as do random monitoring."
"Money market funds that significantly outperform their peers may do so by assuming more risk," the report said. "We therefore recommend that each month, the SEC staff monitor the performance of all money market funds by category and take such action as it may deem appropriate to understand the reasons behind those funds having unusually high performance."
Many financial experts, including former Federal Reserve Chairman Paul Volcker, have advocated a fluctuating or "floating" NAV for money market funds. The working group rejected the idea, saying it would make money funds no different than ultra-short-term bond funds. "We don't believe a floating NAV solves the problem of dealing with high redemptions," Stevens said.
"Investors will reject money market funds that do not have a stable NAV, and a large portion of the assets currently in money market funds will flow into other types of cash pools that are less regulated or outside U.S. regulatory oversight," the report said.
The ability to redeem money funds for their face value is one of their strongest selling points, but if everyone tried to get their money out at once, the funds would buckle.
"Money funds should be better positioned to sustain prolonged and extreme redemption pressures," the working group said, adding that "if a 'run' should strike a money market fund, it must be stopped immediately and with all shareholders treated fairly."
"If a fund has broken a dollar, the real problem is that shareholders who redeem early will get more than those who try to redeem later," Stevens said. "This fuels a cascade of redemptions. Boards should be authorized by the SEC to suspend redemptions promptly when a fund has broken a dollar to minimize losses made up for the guarantee."
Stevens said the authority to suspend redemptions is not intended to lock people into funds and should only be available for a period of about five days, every five years or so.
"Given the important role that money market funds serve in the money market and the economy at large, reforms fundamentally altering or compromising the attractiveness of these funds to investors should be avoided, particularly at a time when the financial markets are so fragile and stabilizing these markets is of such importance to global economic recovery," the report said.
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