Dom Piper: Deconstructing a money market fund

Dom Piper is Managing Director, Global Liquidity with J.P. Morgan Asset Management

Historically the term ‘money market fund’ was a fairly loose catch all definition for various short duration funds ranging from ultra-short government funds through to unrated enhanced cash funds and various absolute return strategies. Regulation has played its part in tightening this definition with the European Securities and Markets Authority (ESMA) introducing specific definitions between a Money Market Fund and a Short Term Money Market Fund. The Money Market Fund definition leaning more toward broader short term fixed income, and the Short Term Money Market Fund definition having more restrictive credit and maturity characteristics.

Local Authority interest in Short Term Money Market Funds has increased significantly over the last few years with levels rising from £226mn in 2007 through to close to £4bn today (Source: Monthly Borrowing (MB) and Quarterly Borrowing (QB) returns as of 31 March 2014). This is unsurprising when viewed in the context of continued credit and interest rate uncertainty, and regulatory changes like Basel III which drives banks to term out their balance sheets.

The first structural objective of a money fund is to ring-fence it’s assets from the balance sheet of the fund sponsor. Essentially the fund should be looked at as a stand-alone company that is wholly owned by its shareholders (investors in the fund). Investors should ensure a good mix of internal and external representation on the fund’s board of directors and should also verify the appointment of good quality service providers; Transfer Agent, Fund Accountant, Custodian, Payment Provider and such like (see diagram). This is all detail that can typically be extracted from a fund’s prospectus, and the aim should be to ensure operational risk is minimised and that investment risk is limited to the assets held by the fund.

This said, when deconstructing a money market fund, its essential to explore in detail the research and investment process employed by the manager. When selecting a money market fund, the research and investment process from one manager to the next is what will make the difference in times of market stress.

Theoretically a AAA rated Short Term Money Market Fund can invest in any security with a short term credit rating of A-1 / P-1. In reality this presents a large universe of investible securities that need to be filtered. It’s important to ensure your manager has a robust credit research team that formalise their insight with rankings of improving, stable, or deteriorating credits. This dictates the tenor and exposure limits for issuers placed on the approved buy list.  In addition, investment managers should regularly stress test their funds to understand how it would react in an interest rate and credit shock environment.

Rigorous credit analysis underpins the core fabric of any money market fund, but in the spirit of ‘deconstruction’ it’s also worth exploring the overall investment process and management oversight that goes hand in hand with managing a fund:

• Security selection: Supply across the curve as well as bid/offer spreads
• Asset allocation: Prevailing market conditions, headline risk, political considerations and demand
• Yield curve: A house view on interest rates, allocation to fixed vs. floating rate securities.
• Strategy: The funds positioning of the weighted average maturity and weighted average life
• Liquidity: A close relationship with investors facilitates efficient positioning of maturities within the fund
• Risk Overview: An internal risk and review ethos that complements that of the regulators and credit agencies

It’s important to note the fundamental objectives of money market funds are 1) preservation of capital, 2) provision of daily liquidity and, 3) after satisfying points 1 and 2, a competitive yield.  Money Market Funds will continue to play an important role in providing an alternative to short term bank deposits, but should not be viewed as a commodity. Treasurers should conduct due diligence to ensure they select the right fund for their own investment profile and objectives.

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