Global Pensions asked a panel of experts to explain how the US subprime crisis had impacted on cash management and money market funds, and how pension funds could make better use of the asset class
How has cash management and the use of money market funds been impacted by the credit crunch?
Joanna Cound: The US sub-prime mortgage market crisis caused a widespread liquidity crunch in the commercial paper market beginning in July 2007 and has yet to be resolved. Hedge funds, experiencing heavy losses and withdrawals, began selling assets and drawing on liquidity stores. This accelerated in early August, as all markets sank in the face of heavy and increased selling. This de-leveraging spread to the broader market, fed by press reports and fears of sub-prime exposure among investment vehicles including CDOs, SIVs, SIV-lites, ABCP conduits, and others. Conservatively managed triple- A rated money market funds have seen significant inflows over the last six months, highlighting investor demand and a flight to quality trade. This is typical in a declining interest rate environment as money market funds tend to hold on to higher yields for longer as interest rates are cut. These inflows were compounded by investors seeking safe havens for their cash investments.
Donald Aiken: Since the onset of the credit and liquidity problems in global financial markets in August 2007, some money market funds have suffered from a number of body blows. However, it is important to make a distinction between the two types of money market funds which are on offer throughout Europe. ‘Investment-style' money market funds, or enhanced cash funds, seek increased yields by sacrificing some capital security and liquidity. ‘Treasury-style' money market funds offer capital security and liquidity, with yield being a secondary concern. The problems in the capital markets have had a significant impact on enhanced cash funds, with some funds temporarily suspending redemptions due to an inability to value their assets. These problems contaminated by association all funds which used the nomenclature of a money market fund, since there is no European definition for such a fund. However, ‘treasury-style' (or ‘liquidity') money market funds have performed relatively well since August 2007. Funds under management have increased to record levels, with the Institutional Money Market Funds Association, the trade association specifically representing this fund type, reporting investment levels at over €350bn, up approximately 20% since August 2007. These ‘treasury-style' money market funds were quickly able to realign their portfolio composition to enable investors to have access to liquidity upon request. These funds are restricted to a maximum weighted average maturity of no more than 60 days, resulting in regular maturity of assets and allowing quick and easy amendments to the portfolio to reflect the changing needs of the investor base. At the height of the credit crunch, these funds were holding approximately 35% on daily deposit (compared to around 15% in more stable markets) to cater for any unexpected withdrawals from nervous investors.
Chris Oulton: The IMMFA funds, which are all Qualifying Money Market Funds (QMMFs) and are also referred to as liquidity funds, differ from other funds as: (1) Their primary investment objective must be to maintain the net asset value of the undertaking either constant at par, or at the value of the investors' initial capital plus earnings; (2) They must invest exclusively in high quality money market instruments with a maturity or residual maturity of no more than 397 days, or regular yield adjustments consistent with such a maturity, and with a weighted average maturity of 60 days; and (3) They must provide liquidity through same day or next day settlement. All the funds are rated AAA by at least one rating agency. Interestingly, the amount invested in IMMFA (Institutional Money Market Funds Association) money market funds grew by around 40% in 2007, possibly as investors looked for greater diversification in their cash holdings. The background to this growth in investment is that the money markets have been difficult for all investors with far more ‘exciting' markets than we have been used to over recent years. The amount of liquid assets available to investors has shrunk dramatically with the virtual disappearance of much of the assetbacked market. Rapid movements in interest rates and changes in the shape of the yield curve have brought challenges as well as opportunities to investment managers. The situation has been further complicated as the most creditworthy names have not wanted or needed to borrow, while the less creditworthy have been faced with having to pay large spreads over LIBOR to obtain the funds they need. These developments seem to have brought an increased focus on the benefits that QMMFS can provide to cash investors.
With the credit crunch problems in mind, why should pension funds still invest in money market funds?
Joanna Cound: Money market funds seek to offer stability, liquidity and yield in that order, which creates an investment vehicle appropriate for meeting short term liabilities in pension funds. We believe that pension fund managers place the spotlight on stability and are not using money market funds as yield vehicles. Chris Oulton: Qualifying Money Market Funds offer pension funds an efficient way of greatly diversifying the exposure of their cash portfolio, while achieving same day access as well as attractive returns. Recent events have demonstrated it is important to diversify investments and this is hard to achieve in a typical portfolio while still maintaining day-to-day liquidity. A QMMF offers investors an opportunity to benefit from being part of a larger pool of cash managed by a specialist manager.
Donald Aiken: Despite the credit crunch, most money market funds continue to provide a means through which to manage short term cash surpluses. Treasury-style money market funds have maintained their ability to provide capital security and daily liquidity in all market conditions - both of which are of paramount importance to all types of investor. The short term nature of these funds, and the importance placed by them on cashflow forecasting, allows them to quickly alter the portfolio composition to reflect changing investor sentiment. Once understood, the treasurystyle money market funds should be seen as a key component of cash management. They provide a means through which the investor can obtain access to a diversified set of instruments which could not be achieved without significant investment by the client, and effectively outsource the management of short term cash balances to a dedicated team of product specialists.
What innovations can we expect from cash as an asset class in 2008?
Joanna Cound: We anticipate that 2008 will be a year of continued volatility in global credit markets. We appear to be witnessing the bursting of the credit bubble, whereby both supply and demand for credit are contracting amid a general deterioration in loan quality. Unfortunately, bubble-bursting tends to take a long time to reach resolution, and we expect to see additional downgrades, writedowns and further evidence of a weaker economy in the upcoming months. That said, we do not see significant innovations in the cash space, but rather a ‘back to basics' approach to money fund investing. We fully expect investors to increase their focus on due diligence on money market funds and seek out investment managers who have built their franchise based upon stringent credit requirements and deep investment research.
Donald Aiken: Cash remains a key component of any liquidity management strategy, including that of pension funds. The need for liquidity has been ably demonstrated during the credit crunch, and therefore ready access to liquidity provisions should be one of the fundamental objectives of all investors. Product innovations in terms of cash management are unlikely in 2008. The credit crunch has reduced the risk appetite of many investors for innovative and new products, usually to generate additional yield, whilst also demonstrating the importance of prudent decision-making. Therefore, 2008 is more likely to see more use of existing products, aligned with greater understanding and utilisation of their intended purposes. Money market funds are likely to be used increasingly as a means through which to obtain access to liquidity, rather than enhanced yield, whilst also providing capital security.
Chris Oulton: We don't anticipate any innovations as such but instead a back-to-basics approach from cash fund managers. The recent market turbulence has highlighted the importance of only investing in secure credits and focusing on liquidity and security and resulted in investors having to reassess the risk return profile which is suitable for a cash portfolio. Managers of Qualifying Money Market Funds will continue to focus on security and liquidity as the key requirements for short term cash portfolios. We may see further segmentation in cash funds. Typically a fund manager will offer a QMMF (liquidity fund) with a maximum weighted average maturity (WAM) of 60 days and an enhanced cash fund with a maximum WAM of up to one year. With the increased focus on security, investors may be interested in ultra conservative short term funds, with a maximum WAM of perhaps under one month and additional segmentation in the enhanced cash area. We anticipate that with the virtual demise of the ABS markets, fund managers will be focused on traditional credits and will look to add value from their portfolio construction.
How could pension funds make better use of their cash holdings?
Joanna Cound: Pension funds, as well as all institutional investors, might consider implementing additional due diligence processes in choosing money managers for their cash holdings. The market has learned that it cannot rely on rating agencies alone, that all A-1/ P-1 rated paper is not created equal and that it is critical to look for an investment manager who embraces this mantra. At BlackRock, we believe that the most significant value that can be added to a portfolio may be achieved through careful issue selection. This careful selection is predicated on intense credit analysis aimed at protecting investors from negative surprises.
Chris Oulton: Pension funds should ensure they are making the best use of all their cash balances, including frictional cash, which can sometimes be neglected and left in bank accounts, which may pay unattractive rates. Qualifying Money Market Funds can offer significantly higher rates, typically in line with seven day LIBID. Currently, they are considerably higher and also offer the benefits of a specialist fund manager. A fund structure also allows pension funds to benefit from the greater diversification and economies of scale that come from investing in a pooled product. Pension funds can also look at identifying core cash holdings as distinct from their frictional cash to see if it would be appropriate to look at investing medium term cash with a longer time horizon, with the possibility of achieving higher returns.
Donald Aiken: Short term cash was once the forgotten asset class: now, its management is equally as important as other classes. Pension funds should ensure that their entire cash holdings are properly invested, but must first understand the underlying nature of that cash in terms of the duration available for investment. Where the cash is short term and volatile, treasury-style money market funds could be used to sweep up all residual cash balances, including any outside of the asset allocation process held with fund custodians. This would then enable a competitive sector-related return to be obtained on the balance, whilst also - and more importantly - providing capital security and liquidity at all times. For balances which are available for investment for a slightly longer duration, i.e. medium term cash surpluses, a pension fund should consider an enhanced cash fund, providing the nature of the fund and the risks associated with it are understood. These funds take a longer term view with an objective of obtaining additional yield. The enhanced yield opportunity results from the usual risk-reward conundrum of higher credit and/or market risk combined with lower liquidity. However, provided this risk is understood and accepted, these funds will continue to provide a valuable means of cash management.
Donald, who joined Morgan Stanley Investment Management in January 2008, is managing director, International Liquidity Business. Prior to joining MSIM, Donald was head of cash services at Scottish Widows Investment Partnership, where amongst other things he successfully launched and managed the second largest sterling institutional money market fund in Europe.
Joanna is managing director, chief operating officer and head of the European sales team for BlackRock's International Cash Business in the Account Management Group. Joanna's service with the firm dates back to 1996, including her years with Merrill Lynch Investment Managers (MLIM), which merged with BlackRock in 2006. Before joining MLIM in 1996, Joanna worked for Fidelity in product development and product strategy, and for Citibank marketing in retail banking and life insurance.
Chris, who has been involved in the liquidity funds industry since 1998, is the founding partner and CEO of Prime Rate Capital Management. He has over 25 years experience in banking and asset management, most recently as head of money market sales at Insight Investment, which he joined in 2004. As an independent consultant, he successfully launched the Abbey AAArated MMF.
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