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.[1] 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.[2]     

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).[3] 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. [4] 

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.[5] Reforms that were adopted by the SEC after the financial crisis put money funds on sounder footing.[6] 

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.[7] 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.[8] 

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.

Board Oversight

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. [9]
• 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). [10]
• What is the portfolio manager’s game plan for the inevitable decrease in interest rates and possible fund outflows?

Risk

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. [11] 

Compliance

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.[12]
• 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.[13]
• 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.[14] 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.