It’s been years since money market funds have received this much attention from investors. Money fund assets have grown this year by over $550 billion, to a record $5.4 trillion in total assets as of the end of May. Investors moved substantial amounts of cash into money funds seeking the higher yields they offered as a result of the Federal Reserve’s rapid interest rate increases, and they fled bank deposit products due to worries regarding the recent failures of three regional banks, beginning with Silicon Valley Bank in early March. Yet, money market funds are not immune to the adverse effects of a rapid rise in interest rates.
The first money market fund to “break the buck” occurred in 1994 with the Denver-based Community Banker’s U.S. Government Money Market Fund. The fund held over 25% of its assets in adjustable-rate structured notes, a type of derivative security. As interest rates increased, these floating-rate securities lost value and ultimately became illiquid, which caused the fund’s NAV to drop below a $1.
In the last decade of low interest rates, money funds were “loss leaders” as fund sponsors supported their yields through management fee subsidies. There was not enough income available from money market securities to cover a fund’s expenses, let alone to offer investors reasonable returns. In fact, because of the ultra-low interest rate environment, fund sponsors (and fund boards) were worried about such arcane things as the possibility of negative yields, which could erode a money fund’s NAV below a $1 per share (for funds that maintain a stable NAV). Interestingly, the Securities and Exchange Commission, in response to industry input, earlier this month permitted money funds to take certain actions in the event of a negative interest rate environment to maintain a stable NAV. 
Back on the Radar
Since the 2008 financial crisis, money market funds have received a lot of attention from everyone but investors. These funds are probably the least risky of all mutual fund products, yet they have arguably attracted outsized regulatory scrutiny. Bank regulators view them as shadow banking products that compete with lower-yielding bank deposit products. They downplay the fact that money funds are subject to market risk like other mutual funds and focus instead on the “implied guarantee” of the $1 stable NAV and systemic risk, citing two historic periods of market stress: the financial crisis and the March 2020 pandemic. Reforms that were adopted by the SEC after the financial crisis put money funds on sounder footing.
Money funds are probably the most homogenized of all fund products due to the stringent requirements of Rule 2a-7 under the Investment Company Act of 1940, which restricts the types of investments a money fund can hold. This rule requires money market funds to hold ample liquidity, to limit interest rate risk by restricting the maturity of assets they hold, to broadly diversify across issuers (for non-government money funds), and to limit credit risk by holding only high-quality, short-term assets. Because of this rule, the funds’ investment programs and the underlying portfolio investments themselves can be strikingly similar. Consequently, money funds compete largely on the other services that are offered to investors, which go to the funds’ convenience as savings vehicles and cash management tools. Also, over the last decade, investor choice has generally been reduced as many fund complexes no longer offer proprietary money funds due to their operational costs, complexity, and lower management fees, which impact profitability.
With the rapid influx of cash flows, the volatility in interest rates, and cracks that appeared in corporate and government credit with the regional bank crisis and the U.S. debt ceiling negotiations, money funds are suddenly back on the radar. When the Federal Reserve inevitably pauses or even reduces its benchmark Fed Funds rate, money fund yields may fall as fast as they recently have risen—and investors may respond by moving precipitously into other investment vehicles, pressuring portfolio liquidity, and potentially bringing a different set of concerns.
How are fund directors supposed to navigate these rocky straits? Fund boards have a fiduciary obligation to oversee the operation of the funds they oversee, regardless of the risk profile and return potential to investors. Because of money funds’ unique structure and the strict regulatory limits on their investments, the type of review required by fund boards for a money fund is a little different from that for an equity or fixed income fund in terms of fund performance, execution of the investment strategy, portfolio characteristics, and other relevant factors and information.
In terms of portfolio management capabilities, fund directors should inquire how the fund manager is responding to the substantial increase in cash flows into the sponsor’s money fund portfolios. The following questions and topics could be helpful to understanding how the portfolio manager is managing risk in the portfolio:
- How is the portfolio manager putting the cash to work, and what is the impact on the fund’s existing portfolio and liquidity?
- Further, how is the portfolio manager addressing risks to the fund’s existing holdings? Even though money fund portfolios hold securities with short maturities, there still could be unrealized losses on those securities due to the increase in interest rates. Can the fund withstand periods of heavy redemptions without having to sell a security that has seen a decline in price? Fund directors should refer to the stress testing reports to monitor these unrealized losses and their impact on a money fund’s market-based NAV. 
- What is the direction of the fund’s market-based NAVs relative to its $1 NAV per share calculated based on the amortized cost of the fund’s investments? Would redemptions cause the fund to recognize losses and cause the market-based NAV to drop significantly below $1, causing a substantial difference between the market- and amortized-based NAVs?
- Does the increase in interest rates present any credit risks to the fund’s underlying holdings? How would the fund react if the rise in interest rates adversely affected certain market sectors or holdings (i.e., causing the default of a security or leading to a credit deterioration across a particular industry)? Note that this is more of a concern for prime and tax-exempt money funds; creditworthiness determinations are not as important for government money funds (except during times of a Federal debt ceiling debate). 
- What is the portfolio manager’s game plan for the inevitable decrease in interest rates and possible fund outflows?
Fund boards are not alone in the monitoring of the risks to a money fund’s portfolio and operations. They have an ally in the sponsor’s chief risk officer and risk management function, and boards should not hesitate to rely on these individuals for an assessment of the risks to the fund complex’s money funds. Here are some pointers regarding risk:
- The board should receive reports from the chief risk officer on how the adviser is monitoring risks in the management of its money funds; and they should review the adviser’s risk monitoring capabilities and protocols.
- Rule 2a-7 requires the fund manager to perform certain periodic stress tests on a money fund’s portfolio and present these findings to the fund board. In light of recent market conditions, these reports can be a useful tool for fund boards, particularly the modeling, which stresses the fund’s market-based NAVs for changes in interest rates. Closer attention to these reports may be warranted in unusual market conditions.
- For boards overseeing institutional prime and tax-free money funds, the July 2023 amendments to Rule 2a-7 will require the fund to potentially impose mandatory redemption fees when a fund experiences daily net redemptions that exceed 5% of net assets, unless the fund’s liquidity costs in meeting those redemptions are de minimis. In addition, the board of a non-government money fund, including a retail prime fund, may require the fund to impose a discretionary liquidity fee (not to exceed 2% of the value of fund shares) if it determines that such a fee would be in the best interest of the fund. As part of the implementation of these new requirements, boards will be asked to review and approve amended fund procedures. In a change from the current rule, the board will be permitted to delegate a fund’s liquidity fee determinations to the fund’s adviser subject to written guidelines and ongoing board oversight of the adviser’s liquidity fee determinations. 
The fund’s chief compliance officer is also someone the board should rely upon and hear from regarding the fund’s compliance with investment policies and the other aspects of Rule 2a-7 that limit risks in the portfolio. In particular, the fund board could request that the CCO focus on the following:
- A review of Rule 2a-7 compliance policies and procedures, with a focus on aspects of the rule relating to the securities eligible for purchase and conditions designed to limit portfolio risk, including the rule’s portfolio liquidity requirements.
- As part of the oversight of fund valuation policies and procedures, there could be a review of those aspects of the policies and procedures that relate to computation of the money fund market-based NAVs and monitoring of those shadow NAVs versus amortized cost.
- The board will be asked to review and approve the fund’s policies and procedures relating to mandatory (for institutional funds) and/or discretionary (for other non-government money funds) redemption fees as part of the implementation of the July 2023 Rule 2a-7 amendments.
- If there has been a substantial increase in money fund subscriptions, consider reviewing the transfer agent’s operational capabilities and results in processing shareholder transactions, including error rates in processing transactions.
Marketing and Distribution
It is important for the fund board to understand how their money funds are marketed and to whom. Is the fund offered exclusively to retail investors, or are institutional investors also eligible to invest? Different requirements apply depending on whether the fund is offered to retail or institutional investors. The SEC requires money funds that are offered to institutional investors to “float” their NAVs (i.e., price their NAVs at current market value). During the financial crisis, institutional investors that held large share positions and had the resources to monitor a fund’s portfolio risks, redeemed shares more rapidly and extensively than retail investors. This so-called “first-mover” advantage can harm a money fund by leaving it with lower assets for other non-redeeming shareholders.
Fund boards should consider how a money fund—particularly an institutional money fund—is marketed and distributed to investors. They should periodically receive reports from the fund’s distributor on the funds’ marketing practices, including how the funds are positioned competitively and how the fund advertises yields in marketing materials and on websites. Boards may want to query how claims of a fund’s principal stability and liquidity are characterized in marketing materials and how these claims match its portfolio characteristics and liquidity profile.
With money funds being back in vogue with investors, there is “no rest for the weary” in terms of the board’s attention to a money fund’s investments and operations. With the help of key allies of the fund adviser, such as the CRO and CCO, fund boards can review the important aspects of the fund’s investment program, the fund’s risk profile and stress tests, and its policies and procedures for compliance with the risk-limiting conditions of Rule 2a-7. Following some of these commonsense practices will help ensure that investor expectations are met and that the money funds truly are among a fund complex’s least risky investment products.
Darrell N. Braman retired in 2020 after 28 years in the legal department at T. Rowe Price Associates, Inc., where he most recently was a managing counsel. He is currently an adjunct law professor at the University of Maryland Francis King Carey School of Law, where he teaches Corporate Finance and Securities Regulation.
Source: Weekly Money Fund Assets; Investment Company Institute
SEC Cease and Desist Order: In the Matter of John E. Backlund, et al. Rel. 1940 Act 23639 (Jan. 11, 1999). The fund was marketed solely to institutional investors and ultimately the fund’s investors recovered approximately 96 cents on the dollar.
Under Rule 2a-7, prime and tax-free money funds that are offered to retail shareholders are not permitted to also be held by institutional investors. Only retail and government funds are permitted to use a stable $1-per-share NAV.
As part of a broader set of reforms designed to shore up the liquidity tools for money funds, the SEC also gave stable NAV money funds the ability to reduce the number of shares outstanding to maintain a stable $1 NAV, in addition to the ability to convert to a floating NAV. Utilization of these measures will be subject to board determinations and disclosures to investors. A fund board will not be able to delegate this determination to the fund adviser. See Money Market Reforms, Rel No. IC-34959 (July 12, 2023).
The March 2020 COVID-induced market break stressed certain prime and municipal money funds, which experienced outflows, and reportedly two funds needed sponsor support, harkening back to the problems that money funds faced during financial crisis. Report of the President’s Working Group on Financial Markets, Overview of Recent Events and Potential Reform Options for Money Funds (December 2020).
The SEC adopted further amendments to Rule 2a-7 around the time of publication of this article, which are designed to improve the liquidity and resilience of money funds in the wake of the market stresses of March 2020. See Money Market Reforms, Rel No. IC-34959 (July 12, 2023).
For simplicity’s sake, I am referring to retail and institutional prime and government funds as opposed to tax-exempt or municipal money funds whose investments will vary based on the state in which they invest. For example, tax-exempt money funds hold short-term state and local government and municipal securities, while government MMFs almost exclusively hold obligations of the U.S. government, including obligations of the U.S. Treasury and federal agencies and instrumentalities, as well as repurchase agreements collateralized fully by government securities.
At year-end 2012, there were 564 SEC-registered money market funds. By April 2023, that number had been almost cut in half to 294 funds. Money Market Fund Statistics, SEC Division of Investment Management’s Analytics Office (May 22, 2023).
All government money funds, as well as retail prime and retail tax-exempt money funds, are permitted to price their shares at a stable “NAV” per share (typically $1) without regard to small variations in the value of the assets in their portfolios. These funds must periodically compare their stable NAV per share to the market-based value per share of their portfolios (or “market-based NAV”). If the deviation between these two values exceeds one-half of 1% (50 basis points), the fund’s board must consider what action, if any, to take, including whether to adjust the fund’s share price. If the repricing is below the fund’s $1 share price, the event is commonly called “breaking the buck.”
Rule 2a-7 used to require money market funds to buy only highly rated securities, but references to minimal credit ratings were removed from the rule in 2015. Although the reference to credit ratings was removed from Rule 2a-7, funds generally invest in the same high-quality instruments. Before purchasing a security, the fund’s manager must determine that it presents “minimal credit risks at the time the fund acquires the security.” Funds also must “provide ongoing review of whether each security (other than a government security) continues to present minimal credit risks.”
The July 2023 amendments also removed the requirement to impose a temporary redemption gate and removed the tie-in between a money fund’s ability to impose a liquidity (redemption) fee to its level of weekly liquid assets. The SEC cited the “unintended consequences” that these provisions had during market conditions of March 2020 when the mere possibility of liquidity fees or redemption gates caused money fund investors to redeem and contributed to fund managers maintaining weekly liquid assets above 30% instead of using these assets to meet redemptions.
The July 2023 amendments also substantially increased the required minimum level of daily (obligations that mature or settle in one business day) and weekly (obligations that mature or settle in five business days) liquid assets for all money funds from 10% and 30% to 25% and 50%, respectively. These requirements are designed to work in combination and ensure that a money fund can receive enough cash within one or five business days to satisfy redemption requests. There are also limits on money funds’ portfolio weighted average life to reduce exposure to credit spreads, as well as limits on funds’ portfolio-weighted-average maturity to mitigate interest rate risk.
See footnote 4 above.
It has been quite some time since money fund yields have been high enough to entice investors to move their cash in search of higher returns. Accordingly, the promotion of money fund yields may take on enhanced importance in the marketing of such funds.