Growing Into Extinction
We are in unprecedented times in the money market fund industry. SEC regulations and Fed policy have created a game of chicken that no one will win.
“It may not be rational to start a bank run, but it is rational to participate in one”
- Mervyn King, former Governor of the Bank of England (2003-2013)
In 1968, Bruce R. Bent and Henry B. R. Brown, two Wall St. veterans who were working together at TIAA-CREF, went off on their own to create Brown & Bent. By 1970 they had launched the Reserve Fund, the first ever money market fund, with an objective to offer modest rates of return and zero market risk. Immediate liquidity and safety were the pillars of the business model. After a NY Times article about Brown & Bent, a recession, a double-digit Fed Funds rate and a falling stock market, assets grew to over $100 million by the end of 1973. During the Great Depression, Congress enacted the Glass-Steagall Act in an effort to improve the safety and soundness of retail bank deposits. A part of Glass-Steagall was Regulation Q, which prohibited commercial banks from paying interest on demand deposits; these restrictions persisted until 1980 and enabled the Reserve Fund to continue its infamous growth. At its peak, the Reserve Fund had over $60 billion in assets. On September 15, 2008, Lehman Brothers (a 1.2% commercial paper position in the fund) filed for bankruptcy. Demands to withdraw funds reached 25% that day for the Reserve Fund and over 50% the following day. Deeming the Lehman assets to be worthless (amongst other financial company mark downs), the Reserve Fund quoted an NAV of $0.97 on September 16th and officially “broke the buck”. The entire Reserve Fund was liquidated by the end of the month; SEC and class action lawsuits ensued.
Fast forward to 2020 – According to the Investment Company Institute (ICI), as of April 15, 2020 there was over $4.5 trillion invested in money market funds in the U.S. This figure has increased $1 trillion since the end of 2019! Retail and institutional assets are piling into money market funds at a record pace. Vanguard, who manages over $400 billion in money market fund assets, announced on April 16th that they were closing their Treasury Money Market (VUSXX) fund to new account holders. Mutual funds most typically manage inflows when they’re running out of capacity, so why would a United States Treasury fund close to new money? It’s the most liquid market in the world. Because they can’t make money, maintain positive yields and maintain a $1 NAV. Between 2009 and 2015, money market funds waived an estimated $35 billion in fees (fee waivers). Companies like Federated Investors have been forced to change their business models while others have outright exited the industry; between 1998 and 2011, the number of money market fund sponsors went from 204 to 117.
This brings us to money market reform. In 2016, the SEC adopted rules for the management of money market funds to enhance the stability and resiliency of the industry. Retail share classes maintained the $1 NAV but were required to institute redemption triggers (exit fees); 1% if assets fell by 10%, 2% if assets fell by 30%. Funds could also suspend redemptions for up to 10 business days in a 90-day period. Due to these draconian measures, many fund companies have converted their prime funds into government-only funds to avoid these restrictions. Institutional share classes, which make up 60% of assets, saw larger changes and were subject to a floating NAV in prime funds. The risk/return profile for large institutional cash changed for good.
So we now have $4.5 trillion invested in U.S. money market funds with an asset-weighted average expense ratio of 26 bps (according to ICI). The simple average and median are far higher, 47 and 43 bps respectively, so many investors are currently invested at meaningfully higher expense ratios. Regardless, that is over $11 billion in revenue that has become more heavily reliant on lower yielding government securities (as opposed to commercial paper) as a result of regulation. Money market funds have to invest in securities with less than a 13-month duration, but 1-year U.S. treasuries are yielding 17 bps (4/21/20). Fund companies were already waiving in upwards of 52% of their fees before regulations were changed; what will they do now that assets have massively shifted into government funds?
Is there a better way? Mutual funds have been a phenomenal democratizing evolution for retail investing, but the current landscape is troubling. Separately Managed Accounts (SMA) have been outpacing mutual fund sales since 2016, however they’ve realized greater penetration in the equity and municipal debt markets. Constructing an SMA of short duration fixed income securities can create a viable and cost-effective alternative to money market funds. A portfolio of low cost, highly liquid fixed income ETFs can result in higher after-tax yields without the dreaded overhang of money market reform and the potential for liquidity challenges and redemption fees. Much work must be done; not all ETFs are created equally. Primary versus secondary liquidity, high-quality Authorized Participants and underlying security details are critical data points to know and monitor. The results of which can be highly valuable and pertinent in our current environment.
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