Barron's Cover
SATURDAY, JANUARY 7, 2012
Broken Forever?
By BEVERLY GOODMAN
Money-market funds are suffering a perfect storm of economic and regulatory issues. But it's investors who should batten down the hatches.
What's the difference between a piggy bank and a money-market fund? Not much.
Neither is insured, and the returns are basically the same: nothing. The average
money fund these days pays just two basis points, or 0.02%. A third of them pay
nothing at all.
Yet in November and December 2011, investors put more cash into money funds -- $91.7 billion -- than they had since December 2008 and January 2009, when $195 billion poured into the funds. Retail assets account for about a third of the $2.7 trillion held in domestic money-market funds.
The reason for that is safety. And that's where the trouble begins -- both for the companies that run money-market funds and the individuals who stash their money there.
Yet in November and December 2011, investors put more cash into money funds -- $91.7 billion -- than they had since December 2008 and January 2009, when $195 billion poured into the funds. Retail assets account for about a third of the $2.7 trillion held in domestic money-market funds.
The reason for that is safety. And that's where the trouble begins -- both for the companies that run money-market funds and the individuals who stash their money there.
There are three big reasons for this, starting with the Federal Reserve. The
Fed has made clear that it plans to keep overnight rates at their historic lows,
which means that the securities money funds buy are also yielding exceedingly
low rates. And low rates make it exceptionally hard -- virtually impossible, in
fact -- for the funds, and therefore investors, to make any money.
.
It's a lot easier to generate a respectable yield for investors and collect a
fee when interest rates are at 9.5%, as they were in 1989, or even at 3.5%, as
they were in the beginning of 2008. But since the financial crisis hit, the Fed
has lowered its target overnight fed-funds rate to 0.25%. The London Interbank
Offered Rate, or LIBOR, the European benchmark interest rate, is at the same
level. Most money-market fund expense ratios, meanwhile, range from 0.15% to
0.5%, though some can run higher.
How costly? Three years ago, the money fund industry brought in $13 billion in revenue. In 2011, that number fell to an estimated $5.1 billion. "But how much does it really cost to run a money fund?" says industry expert Peter Crane of Crane Data. "A couple of million will cover the portfolio managers and Bloomberg terminals." So while revenue has been decimated, money-fund operators are still making money.
THE REGULATORY ENVIRONMENT is another challenge, and many money funds just finished complying with SEC rules that were passed and implemented in 2010. The rules, which caused many funds to rejigger their portfolios, are aimed at reducing risk, ensuring liquidity and increasing transparency. (For a quick take on money-market funds and the rules that govern them, see "A Brief History of Money-Market Funds" at the bottom of the article.)
Not surprisingly, most in the industry argue more rules aren't needed or should at least be delayed. "This was a very, very impactful change in terms of how funds are positioned," says Nancy Prior, president of Fidelity's money-market group. "Since these changes, money funds have been through the near-default of the U.S. government in July, the downgrade in August and the continuous deterioration across Europe. And yet the funds have done very well and have been flush with liquidity in this time of incredible duress."
However, some powerful forces urge more rules and oversight. Former Fed chief and current regulatory gadfly Paul Volcker has argued strongly for greater regulation.
"Free of capital constraints, official reserve requirements and deposit insurance charges, these money-market funds are truly hidden in the shadows of banking markets," he said in a September speech.
Many of the newer proposed regulations are aimed at preventing the proverbial run on the bank, which is more innocuously known as the "first-mover advantage." When investors either sense or actually spot a problem with a money fund, the first to withdraw generally can get all their money. But as assets shrink, problematic holdings become a larger portion of the fund, making it more likely to break the buck, leaving the less-panicked investors to bear the cost.
A few proposed regulations focus on a capital buffer, which would essentially be a stash of money that's put up by either the fund management, the shareholders or a combination of the two.
"If the regulation requires fund companies to provide the capital, it could create an oligopoly," says Deborah Cunningham, Federated Investors' chief investment officer for taxable money-market funds. "The smaller players won't be able to put up the money. You can't get blood from a stone."
The most dramatic regulatory proposal is one calling for a floating NAV, or net asset value. That would mean that money funds would no longer be able to round their share price to a dollar.
"People see that as a nuclear alternative," Swirsky says. "A floating NAV really changes what money-market funds are." What's more, Swirsky points out, a 2009 study by the Investment Company Institute, the lobbying and policy arm of the mutual-fund industry, showed that short-term bond funds suffered significant outflows in troubled markets. "In other words," Swirsky says, "a floating NAV won't prevent runs."
The third major challenge for the industry is the supply of available investments. New banking regulations encourage longer-term financing, which means the supply of shorter-term debt is shrinking. Proposed regulations for the sponsors of asset-backed securities require those debt issuers to keep a certain percentage of the value to back up the securities to keep skin in the game.
That could make asset-backed securities more costly to issue, which also would constrain the supply of a security in which many money funds invest. This supply constraint, paired with an increase of demand for shorter-term investments as a result of new regulations, means that already-low yields will remain under pressure. "The main challenge for money-market funds will be to navigate these supply constraints, while maintaining fund credit quality," says Moody's senior analyst Michael Eberhardt in a recent report.
How costly? Three years ago, the money fund industry brought in $13 billion in revenue. In 2011, that number fell to an estimated $5.1 billion. "But how much does it really cost to run a money fund?" says industry expert Peter Crane of Crane Data. "A couple of million will cover the portfolio managers and Bloomberg terminals." So while revenue has been decimated, money-fund operators are still making money.
THE REGULATORY ENVIRONMENT is another challenge, and many money funds just finished complying with SEC rules that were passed and implemented in 2010. The rules, which caused many funds to rejigger their portfolios, are aimed at reducing risk, ensuring liquidity and increasing transparency. (For a quick take on money-market funds and the rules that govern them, see "A Brief History of Money-Market Funds" at the bottom of the article.)
Not surprisingly, most in the industry argue more rules aren't needed or should at least be delayed. "This was a very, very impactful change in terms of how funds are positioned," says Nancy Prior, president of Fidelity's money-market group. "Since these changes, money funds have been through the near-default of the U.S. government in July, the downgrade in August and the continuous deterioration across Europe. And yet the funds have done very well and have been flush with liquidity in this time of incredible duress."
However, some powerful forces urge more rules and oversight. Former Fed chief and current regulatory gadfly Paul Volcker has argued strongly for greater regulation.
"Free of capital constraints, official reserve requirements and deposit insurance charges, these money-market funds are truly hidden in the shadows of banking markets," he said in a September speech.
Many of the newer proposed regulations are aimed at preventing the proverbial run on the bank, which is more innocuously known as the "first-mover advantage." When investors either sense or actually spot a problem with a money fund, the first to withdraw generally can get all their money. But as assets shrink, problematic holdings become a larger portion of the fund, making it more likely to break the buck, leaving the less-panicked investors to bear the cost.
A few proposed regulations focus on a capital buffer, which would essentially be a stash of money that's put up by either the fund management, the shareholders or a combination of the two.
"If the regulation requires fund companies to provide the capital, it could create an oligopoly," says Deborah Cunningham, Federated Investors' chief investment officer for taxable money-market funds. "The smaller players won't be able to put up the money. You can't get blood from a stone."
The most dramatic regulatory proposal is one calling for a floating NAV, or net asset value. That would mean that money funds would no longer be able to round their share price to a dollar.
"People see that as a nuclear alternative," Swirsky says. "A floating NAV really changes what money-market funds are." What's more, Swirsky points out, a 2009 study by the Investment Company Institute, the lobbying and policy arm of the mutual-fund industry, showed that short-term bond funds suffered significant outflows in troubled markets. "In other words," Swirsky says, "a floating NAV won't prevent runs."
The third major challenge for the industry is the supply of available investments. New banking regulations encourage longer-term financing, which means the supply of shorter-term debt is shrinking. Proposed regulations for the sponsors of asset-backed securities require those debt issuers to keep a certain percentage of the value to back up the securities to keep skin in the game.
That could make asset-backed securities more costly to issue, which also would constrain the supply of a security in which many money funds invest. This supply constraint, paired with an increase of demand for shorter-term investments as a result of new regulations, means that already-low yields will remain under pressure. "The main challenge for money-market funds will be to navigate these supply constraints, while maintaining fund credit quality," says Moody's senior analyst Michael Eberhardt in a recent report.
WITH THE INDUSTRY UNDER so much pressure, it's likely that investors will see some fallout. The notion of a negative yield -- which amounts to investors' losing money or, more politely phrased, paying for safety -- is dismissed by the biggest funds. "Advisors are already subsidizing portfolios to keep yields positive," says David Glocke, head of Vanguard's money-market group. "There's no reason for that to change. A lot of advisors are in this for the long haul. This isn't an asset class we're walking away from."
That's probably true for the biggest players, says Crane. The money-fund industry is highly concentrated. More than 75% of all money-fund assets are in 10 firms, as of Nov. 30, according to Crane Data. Fidelity is by far the largest, with $423.5 billion in money-fund assets, or 17% of the industry total (see table). And nearly 96% of all assets are held by just 25 firms. The rest is spread out among more than 50 firms. As the industry remains under pressure, chances are that the concentration among the top firms will become even greater.
"We will undoubtedly see more consolidation, but less than people expect," says Crane. "Most of the consolidations or liquidations we've seen are from funds run by AARP and PayPal. They were never really in the business in the first place."
The notion of paying for safety, however, isn't far-fetched, Crane says. "Negative interest rates are nothing new. They used to be called checking accounts," he says. "For centuries, people have paid banks to hold money, not the other way around. There's always been a price for safety, and people are always willing to pay."
"The 0% interest-rate regime has socialized the money-market industry," says James Grant, editor of Grant's Interest Rate Observer and a noted skeptic. "There's no amount of work they can do to make it worthwhile for the investor." That's because all money funds -- aside from those that invest only in U.S. Treasury securities -- contain some risk.
The European debt owned by many funds has garnered a lot of attention, but that isn't the only problem, Grant says. He points to the fact that many funds hold debt issued by Goldman Sachs (ticker: GS), Credit Suisse (CS), Citigroup (C) and the like. "These are all still highly levered companies that got into trouble the last time. Why not again?"
Contrary to the insistence of the money-fund industry, there are safer -- and in some cases, better-yielding -- alternatives. Before sizing them up, you first must look at why your money is in cash in the first place. For example, money-market funds are necessary for investors to easily enter and exit the market. From an investing standpoint, that is the main purpose of cash. "The virtue of cash is not what it earns you," Grant says. "It's that it affords you an opportunity if an asset class steps in front of a bus.
That is the point of cash -- for unexpected investing opportunity." All-Treasury money funds are offered by Fidelity, Federated, Vanguard and all of the major money-market houses. Another alternative: funds that invest Treasuries and government-backed paper from the likes of Fannie Mae and Freddie Mac.
IF SAFETY IS YOUR CONCERN, you're better off in an account insured by the Federal Deposit Insurance Corp. Checking, savings and money-market deposit accounts -- unlike money funds -- are insured by the FDIC up to $250,000 per account holder per institution. (Money invested in money-market funds prior to Sept. 18, 2008, was briefly protected by the federal government in the aftermath of the financial crisis, but that protection expired in September 2009.) And today's low-rate environment is perversely beneficial for some bank accounts -- non-interest-bearing accounts have unlimited protection through 2012, and there's talk of extending that guarantee. That means giving up a basis point or two in return, but that's a small price to pay for insurance.
Retail investors seem to have caught on. The $2.7 trillion money-fund industry peaked at $3.9 trillion three years ago. Though many of those outflows were from institutional funds, individuals withdrew more on a percentage basis.
A Very Concentrated Industry
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More than 75% of all money-fund assets are held by 10 firms, and 95.7% of all money-fund assets are housed in the top 25 firms.
| Fund Family | Assets (bil) | Market Share |
Fidelity |
$423.5 |
17.0% |
| JPMorgan | 249.2 | 10.0 |
| Federated | 243.3 | 9.7 |
| Vanguard | 163.9 | 6.6 |
| Schwab | 157.0 | 6.3 |
| Dreyfus | 154.1 | 6.2 |
| BlackRock | 145.1 | 5.8 |
| Goldman Sachs | 140.0 | 5.6 |
| Wells Fargo | 130.2 | 5.2 |
| Northern | 67.9 | 2.7 |
As of 11/30/11
Source: Crane Data
If you're looking to eke out a bit more return, you still can do so in an insured account. And, in some cases, you might not even have to leave your brokerage to do so. Fidelity, Charles Schwab (SCHW), E*Trade (ETFC) and virtually all their rivals offer a checking account with FDIC protection. When these accounts were introduced, they were billed as "high-interest checking," but these days that moniker has been dropped, though you still might do better in them than in some money funds. On average, interest-rate checking accounts yield 0.23%, while regular savings accounts with at least $10,000 in them yield 0.19%, according to data provider iMoneyNet.
Certificates of deposit are another alternative. You will get, on average, 0.19% for a three-month CD, and 0.29% for a six-month. While CDs generally assess a penalty of 90 or 180 days' worth of interest for early withdrawals, the extra yield you will pick up on a longer-term CD might still make the proposition worthwhile. Ally Bank, for instance, offers a four-year CD that pays 1.6%, with a 60-day early withdrawal penalty.
If you are hoarding a particularly large emergency or short-term cash reserve, you can also consider a two-tiered system, keeping half or two-thirds in an FDIC-insured account and the rest in a short-term bond fund, like the T. Rowe Price Short-Term Bond Fund (PRWBX), which yields 2.3%.
In sum, money-market funds, which were created in the 1970s to give investors a better shake than non-interest-bearing bank accounts, look badly broken. And they are likely to stay that way as long as the no-yield environment persists.
But that won't last forever. Until then, the riskiest funds are those with assets of $1 billion or less that are not part of a larger institution. If your cash is in one of them, consider moving it now, while you still can.
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A Short History of Money-Market Funds
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Money-market funds have a storied past and a daunting future. The first sponsor, the now-infamous Reserve Fund, was established in 1971 via a regulatory loophole that circumvented a rule that limited the interest that banks could pay on demand deposits.
Within 25 years, there were 487 funds. By 1999, the number of funds had risen to 1,045 with $1.6 trillion in assets. Assets peaked at $3.9 trillion in 2009, but consolidation had brought the number of funds down to 704. The Reserve Primary fund was one of the largest.
The Reserve Primary Fund made headlines in 2008 when it "broke the buck" as a result of owning too much debt issued by Lehman Brothers. The Primary Fund, which had assets of $63 billion at the time, held just $785 million in Lehman-issued securities -- about 1.25% of the fund's total assets.
But investors got spooked and withdrew their money in droves, leaving the fund unable to meet redemptions. The next day, the fund announced that its net asset value had fallen to 97 cents.
The Reserve Primary Fund has since been liquidated and its parent, the Reserve Management Co., was charged with fraud and misleading investors. Breaking the buck, in other words, also breaks the fund and, if poorly handled, also can break the company.
Money-market funds don't calculate their net asset values the way mutual funds do, by dividing the funds' total assets by the number of shares. Instead, they're essentially allowed to assume that their NAV is always $1, so long as their "shadow NAV," which is also calculated weekly, doesn't fall below 99.5 cents. Because of the short-term nature and high quality of the securities that money funds buy, this hasn't been seen as a problem -- until recently.
In 2010, the Securities and Exchange Commission, which oversees money-market funds in accordance with the same rules that govern mutual funds, quietly but significantly introduced requirements for their portfolio holdings. Money funds now must hold 10% of their assets in securities that can be liquidated for cash in one day and 30% in seven days. They also had to reduce the maximum weighted average maturity of their holdings to 60 days from 90 days.
The new regulations also allow a fund that has broken the buck (or is about to do so) to suspend redemptions to allow for "the orderly liquidation of fund assets."
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-- B.G.
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved
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