Just when it seemed that the well-publicized bailouts of a few large money market funds were behind us, there came news of a small institutional money market fund breaking its $1,00 per share net asset value. The use by some of these funds of a variety of yield-enhancing derviative instruments, many of which had inappropriately volatile price characteristics, points out what can happen when not enough emphasis is placed on sticking to the fundamentals of money fund management.
This recent turmoil underscores that the primary investment goal of money market funds -- preservation of capital -- must be the first priority in buying securities for a money market portfolio. While investors in money market funds want high short-term yields, their paramount concern is safety of principal. Funds that are managed in a manner inconsistent with the need to maintain a stable $1.00 net asset value are an anathema to the shareholders. Investors choose money market funds for their stability.
It should follow, then, that any investment bought for a money market fund portfolio must adhere to the cardinal rule of maintaining its value at, or close to, its amortized cost value in order to assure that stability.
The best way to practice this most basic tenet of money fund management is to follow the fundamentals of risk analysis; that is, the careful and comprehensive study of both the interest-rate and credit risk of individual investment instruments bought for a fund.
Obviously, interest-rate risk has been particularly problematic of late. Funds that sought to enhance their competitive position in a low-yield environment by buying some of the potentially more volatile derivative instruments suddenly found that their risk analysis had been somewhat off the mark. When the Federal Reserve began raising key rates in the late winter, many of the derivative investments that seemed so attractive when they were originally purchased began looking less so. As interest rates rose, prices of many of these yield-boosting investments dropped; for some funds, this put that constant $1.00 net asset value in jeopardy.
Not everyone, of course, bought such unusual instruments as range floaters, COFI floaters, dual index floaters, or various other exotic investments. Of those funds that did, apparently some needed infusions of additional capital to maintain fund stability. The fact is that the overwhelming majority of fund managers did practice the fundamentals of risk analysis in managing money market portfolios, and that should be read as encouraging news for the industry.
The key to risk analysis is the painstaking, but time-honored process of due diligence. Evaluating interest-rate risk must be done carefully and, above all, comprehensively, taking into account the likely impact of all likely rate scenarios -- rising, falling, and stable -- on future value.
Making investment decisions strictly on the basis of yield can be an imprudent strategy. A wiser approach when considering a fund, or instrument, that bears a particularly attractive yield, is to adopt a certain sense of skepticism. If a fund is reporting a yield that is significantly above the industry average in that fund category, one should probably question whether that fund's expenses are that much lower than average or whether that fund is taking undue risk in its underlying investments. In investing, as in life, things that look too good to be true usually are.
Enhanced regulatory guidelines notwithstanding, it would also be wise to bear in mind that Wall Street will probably be creating new "synthetic" securities, instruments that boost investment yields and fall just within current SEC definitions of what is an appropriate money fund investment. It is extremely important that these instruments be studied with care, for what looks good today could turn out to be on tomorrow's problem list.
Credit risk analysis should be undertaken with no less diligence. And, as the experience of the late 1980s has taught, it is not always enough to rely strictly on the rating agencies to judge the creditworthiness of corporate issuers of securities. Fund sponsors should conduct their own due diligence research to assure the appropriate level of credit risk. A further step can also be taken in this risk analysis process; that is to assure, as Fidelity and others in the industry do, that money funds monitor compliance with their list of approved investments daily and mark to market daily.
Intensive risk analysis is an indispensable tool, as, or even more important in managing a money market fund as it is in extending a banking line of credit. With that said, there are a number of basic questions to bear in mind when buying or distributing a money market fund:
* Again, when looking at a fund's attractive yield, it might be helpful to wonder why it is so attractive. Take a close look at how the yield is realized and what underlying instruments are putting it above the average for that fund category.
* Determine the experience level of the people involved in managing the fund. Find out how long the fund company has been managing money market funds and what its collective resources are. Ask about how well trained its fund managers are, whether they specialize only in money fund management, and if so, whether they further specialize in managing particular types of money market funds. A very important related question to ask is whether they've managed through previous interest-rate cycles in the past.
* Get an idea of what resources the fund company devotes to credit analysis and whether the research function is segregated, as we believe it should be, from the fund management function.
* Find out how frequently and by whom the fund's mark-to-market valuation is done. It should be done on a daily basis and by someone other than the fund manager.
Most important is to remember that the investment goal of money market funds is preservation of capital. Consistent with that goal, it is always best to first investigate and evaluate the investment policy of a money market fund based on parameters of credit quality. Thereafter, consider the depth and strength of the fund's management team. Only when these fundamentals are fulfilled is it appropriate to look at yield.
