Just when it seemed that the well-publicized "bailouts" of a few large money market funds were behind us came news of a small testimonal money market fund breaking its $1-per-share net asset value.
The use by some funds of a variety of yield-enhancing derivative lnstruments -- 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.
The recent turnmoil underscores that preservation of capital. the primary investment goal of money market funds. 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 net asset value are anathema to shareholders.
Investors choose money market funds for their stability.
It should follow 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,
Effective risk analysis requires 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 their risk analysis had been somewhat off the mark.
When the Federal Reserve began raising key rates late last winter, many of the derivative investments that seemed so attractive when they were originally purchased began looking less so
As interest rates rose, the price of many of these yield-boosting investments dropped. The result: Some funds constant $1 net asset value ended up in jeopardy.
Not everyone, of course. bought such unusual instruments as range floaters. Coil floaters, dual-index floaters, or various other exotic investments.
Some of the funds that did look to these instruments apparently needed infusions of additional capital to maintain fund stability.
But 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 on future value of all likely rate scenarios rising, falling, and stable.
Making investment decisions strictly on the basis of yield can be an imprudent strategy. A wiser approach when considering a fund or mstrument 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, investors 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 likely be creating new "synthetic" securities instruments that boost investment yields and fall just within current Securities and Exchange Commission definitions of what are appropriate money fund investments.
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.
As a further step in the risk analysis process, ensure -- as Fidelity and others in the thoustry do that money finds on daily basis, are marked to market.
And conduct monitoring to comply with the funds' approved lists of investments.
Intensive risk analysis is a indispensable tool to manage a money market fund. With that in mind. there are a number of basic questions to consider when buying or distributing a money market fund:
* When looking at a fund's attractive yield, it is helpful to wonder why that return is so good. 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 how well trained the fund maagers are whether they specialize only in money fund management, and if so, whether they further specialize in managing particular types of mony market funds.
Also very important: Ask whether they've managed through previous interest rate cycles.
* Get an idea of what resources the fund company devotes to credit analysis and whether the research function is segregated, as 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 importantly, recognize that the investment goal of money maker funds is presevation 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 maagement team.
Only when these fundmentals are fulfilled is it appropriate to look at yield.