Money market funds come in from the cold
The only sure-fire success for a fund promoter in recent times has been to offer investors some form of safe haven. Anything that has provided the promise of low volatility and a return of the invested principal has found a willing buyer. Money market funds have been one such success. Low yielding, unexciting and largely untroubled by uncertainty. Perfect for the risk-averse European investor.
The market in Europe for these funds has grown dramatically in the last five years and particularly since the introduction of the single currency. The market was worth less than $1bn in 1995. More significantly, it has grown from less than $50bn in 2000 to around $150bn (E131bn) today. And if the US is any guide, this is just scratching the surface. At the end of 2002, there was $2,228bn in US money market funds. With yields at historical lows, though, what are the attractions of these funds?
The use of Triple-A-rated funds is now recognised as a legitimate means of achieving diversification without compromising on security. Yields may not be much higher than on bank deposits, but at least with a professionally managed portfolio, you are gaining whatever incremental advantage is available.
It is important to differentiate between the new breed of liquidity funds and the traditional money market funds that have dominated fund sales in France, Switzerland and Germany for the past 20 years. The money markets segment of the total fund assets in Europe has always dwarfed the numbers invested in equity funds, which is why information service providers always strip away the Luxembourg and Swiss money market funds when assessing growth patterns across Europe. These traditional domestic funds have typically offered more in terms of yield, but at the expense of maintaining a stable NAV. The attraction of the newer funds is their adherence to the US style of capital preservation as the most important criteria.
In the US, money market funds are governed by SEC rule 2-A7 which dictates that the priority of the fund is to preserve the underlying capital values. While European funds are not subject to the same degree of regulation, they have nonetheless adopted this stable NAV approach.
This has in turn, made it easier for European fund rating agencies to convey Triple A ratings on European money market funds. While the Triple A rating confers a seal of approval for the investor, there are still differences in credit quality between the different issues that the rating doesn’t necessarily reveal. So for an investor, it is important to study the overall composition of a fund.
Diversification is a key attribute for institutional investors, especially small and medium sized firms, who are looking for investments that help them manage their risk exposure. Money market fund managers have access to the broad spectrum of cash instruments and they can also call on the best research on these markets. With so many new euro instruments on offer, one needs a large credit analysis function to stay on top of the market, and with so many specialist funds available, it has become a hard cost to justify for many non-financial institutions.
One of the main functions of the money markets is institutional cash management. Indeed, the biggest driver of growth in European assets has been the greater focus by institutions on the efficiency of their treasury function. There is a new emphasis within many corporate treasuries on executing higher value-added work than seeking out the most competitive rates. The money market fund promoters would argue that a corporate treasurer has better things to do than spend all day analysing market rates and credit ratings. Without the constant monitoring of bank rates and bond yields, an institution will probably be investing at sub-optimal rates, so the fund option has many attractions. The euro has made a huge difference too; cash management is no longer complicated by currency exposure in the Euro-zone, and same-day settlement systems have allowed cross-border cash management.
The actual growth for the asset class remains as strong as ever, at least according to UK-based Institutional Money Market Funds Association. The IMMFA represents the Triple A funds that will typically be used by investing institutions. Its figures show that while growth has slowed, year on year growth to the end of the third quarter was 19.7% as an industry average. Euro money funds led the way, increasing by over 43% to $21.4bn. Sterling funds increased by 23.5% to $28.2bn.
A new confidence in equity markets is now causing a shift in asset allocation that has weakened the dominance of money market funds. Diana Mackay at Feri Fund Market Information comments: “There is a consistent asset allocation shift developing in Europe. Twelve months ago, money market funds accounted for 96% of net fund sales. This year they accounted for 36% for the same time period (September to September).”
It wasn’t all one way traffic though. FERI’s figures show that investors remained cautious about equity markets and that in France and Italy, flows into money markets actually increased in the later summer months.
They may have lost much of their immediate attraction, this year, but money market funds are assured of a bright future because of their appeal to a wide variety of institution, from small and medium sized businesses through pension funds and corporate treasuries, to custodian banks, who use them for cash sweep facilities, where the banks move client funds off their balance sheets in a way that profits both parties. In the US, it is estimated that at least 15% of the total market is made up of bank holdings.
There is also the issue of management fees to consider, as Standard & Poor’s have highlighted in their study of fund fees. Management fees for money market funds tend to be in the range of 15 to 25 basis points. However, according to S&P: “we also have found that there is often no correlation between fees, volatility and historic returns. In theory, the riskiest sectors, which offer the best likelihood of returns, could potentially justify the highest fees. And this is certainly true if we look at broad sector categories: equity sectors tend to be riskier and have higher management fees than fixed income sectors. With equity markets being at their gloomiest, the average equity unit trust has lost 26% over the last three years, with a volatility of 6.45, while charging higher front end and annual management fees than fixed income funds which have had an average three year return that is considerably higher.”
The good news for money market fund investors is that they charge less than a quarter the fees levied by fixed income funds, while being more than nine times less volatile. And as S&P observe, “They have had the best performance over the last one and three years, understandably given recent market conditions, by far outperforming bank deposit and building society rates. The latter, represented by the S&P UK Savings 2500 index, have provided an average return of 1.21 last year, free of charge.”