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Impact Investing

IPE special report May 2018

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Time for a fresh look at money market funds

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In recent months, money market funds have begun to attract the interest of institutional investors in the UK pension market. Much has been written about them in the UK press as a new product to hit the market. Set up predominantly in Ireland by mainly US-based institutions, originally for their US clients’ ‘offshore dollars’, they have been latterly finding a ready market in UK institutional cash management. But in continental Europe, it is a different story.
There, ‘money market funds’ have been around for 20 years, are a $390bn (e385bn) market and fully understood. Or are they?
In both the US and Europe, money market funds have had a history since the early seventies and eighties respectively, driven in both regions by the search for high interest rates. In both instances, the demand came from the public sector which was frustrated by the limitations placed on interest rates paid on deposit accounts. But from there on, the similarity ceases, as the other principal driver in the US was the concern to improve the safety of cash investments over deposit accounts.
In the US, the banking system was then in disarray and it was not long before the corporate and institutional sector became interested in money market funds for its own purposes; our group launched its first institutional money market fund in 1980. The popularity and success of these funds brought the level of their assets to $100bn in that year. Meanwhile, the Securities and Exchange Commission had begun to codify how the funds should operate in order to curtail some of the practices that were being followed. This resulted in the amendment of the Investment Company Act 1940 which now included clauses detailing money market funds under a Rule 2a-7 section.
This rule defined construction, instrument eligibility, pricing, calculation of yields and all matters legal and fiscal. After a series of amendments along the way, in 1991 it further made it illegal for any fund to use the term ‘money market’ unless it met the risk limiting conditions of Rule 2a-7. The final action which set the funds on the course for explosive growth was the demand by institutions for constant third-party supervision of Rule 2a-7 funds. This resulted in the rating agencies drawing up a rating process which could calibrate the funds within the confines of the regulations. This saw assets dramatically increase to current levels of $1.6trn, which includes around 40% of all US corporate and institutional liquid assets.
In continental Europe, a very different story ensued. Each country took its own approach to developing a money market fund sector. France, for example, has the largest money market fund market, with over $180bn under management. But this has declined from the well over $200bn level it was at during the early nineties. This loss of assets has been generally echoed throughout most of European countries. The reasons are that money market funds never really progressed beyond the retail sector and therefore fell prey, amongst other things, to the increase in interest in equity investments.
The fact that European money market funds remained a retail product was partly due to the perceived soundness of the continental European banking system. But it was also due to the lack of any conformity of these funds across Europe, compared to the strict Rule 2a-7 in the US. To start with, there is no defined set of rules governing investments and quality. European funds can and do include fixed income investments in their portfolios. This leads on to the creation of funds with variable net asset value whereas US style 2a-7 funds are managed to maintain a constant net asset value of $1 per share.
Rule 2a-7 ensures protection of principal value with interest accruing separately during the month. Rule 2a-7 funds therefore have a constant share price with a monthly dividend, whereas European funds generally have an accumulating share price, piling interest upon, possibly variable, capital.
Liquidity is same day in Rule 2a-7 funds; in European funds it can be anything up to seven days before settlement back to the investor can be made. In European funds, there may be charges into and out of the funds with annual fees up to 1% per annum; in Rule 2a-7 funds, there is no charge in or out, with fees for institutional funds averaging 30 basis points with some as little as 10 basis points.
The final difference is in the overall risk assessment of the funds. Out of 660 money market funds in France, only 16 have been assigned a ‘triple-A’ rating from the rating agencies. The only other indigenous triple-A funds in Europe include one each from Andorra and Italy and seven in Luxembourg.
In the US there are over 1,300 money market funds which follow Rule 2a-7 principals.
All these factors have made European money market funds unattractive as a secure, pure, cash management product for institutional investors. On the other hand, European banking has been resilient to change, but changing it is. As bank ratings continue to fall and as banks merge, the choice of quality banks is diminishing. Together with the eventual withdrawal of state guarantees from a number of European banks, it will not be long before European institutional investors realise that there is only one ‘triple-A’ bank, by all three rating agencies, left in Europe. At that point, the demand for quality cash investments will cause a reassessment of the value of money market funds in favour of the US style, Rule 2a-7 variety.
Mark Doman is managing director at AIM Global Advisors in London

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