In safe hands?

Capital preservation is generally a prerequisite of the term 'safe'. For Cash funds’ it is their primary objective. The IMA sector encapsulating Cash funds even describes them as 'Funds principally targeting capital protection'. However, that IMA sector is not called 'Cash'. It is named 'Money Market funds'. You may, therefore, assume that Money Market means 'Cash', ergo Money Market means 'safe'. Combine this thinking with our experience of markets over the past few years, and it’s unsurprising that this sector has lured investors there to varying degrees. However, as some investors discovered in 2008/09, some of these funds don’t necessarily behave like Cash.

They may not even invest in deposit accounts.

Now there may be good reason for this. Compensation would be limited were a depositor to fail. There is a limited number of deposit takers available with whom to spread the risk. The Money Market is a highly liquid, diverse area that can provide returns marginally superior to Cash, with similar degrees of risk. It is for this reason, for example that in the Life fund space, the Skandia Deposit Fund is transferring its deposit investments to the BlackRock Institutional Sterling Liquidity Fund, in order to bring customers a wider range of investment types, reduced reliance on the limited range of term deposit providers in the UK, and rigorous independent credit research from a world-class fund manager. However, there is a wide diversity of Money Market instruments, and it is important to understand their potential impact.

As stockmarkets trade stocks, the Money Market trades money. Just as companies raise long-term capital by issuing shares or bonds, institutions borrowing over short periods, ie up to 13 months, do so by issuing short-term IOUs, known as 'paper'. The money market mainly consists of banks borrowing and lending to each other using paper in various forms; usually benchmarked to the London Interbank Offered Rate (LIBOR) and traded like bonds. Finance companies typically fund themselves by issuing large amounts of 'Asset-backed Securities' (ABSs)
– commercial paper secured against eligible assets like credit card or mortgage payments.

Until recently, the Investment Management Association defined funds investing in this market, with the catch-all title 'Money Market funds', as 'Funds which invest at least 95% of their assets in Money Market instruments ie Cash and near Cash, such as bank deposits, certificates of deposit, very short-term fixed interest securities or floating rate notes'. As mentioned, it also describes those funds as targeting capital protection; in other words, NO LOSS. So what are the investments that such a fund might choose to hold?

Money Market instruments include Certificates of Deposit (CDs), which are time deposits commonly offered to investors by banks and building societies. Repurchase agreements are short-term loans between one day and two weeks that are facilitated by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date. Commercial paper is unsecured IOUs issued on behalf of companies, with a fixed maturity of between 1 and 270 days; usually sold at a discount from face value. Treasury bills are short-term debt obligations of a government that are issued to mature in three to twelve months.

UK retail Money Market funds which held FRNs and ABSs through the credit crunch in 2008/09 saw prices fall dramatically. At least one UK retail Cash fund lost 9%. While now recovered, these funds face the problem of even lower interest rates. In 2008, when LIBOR stood at over 6%, a fund’s annual management charge of 0.5% was ignored. When LIBOR fell to 0.54% in September 2009, suddenly even the safest of funds faced the dilemma of delivering any return to investors, without increasing risk. Mercifully, a number of funds decided to reduce, or suspend, their management charges for a period to compensate for this. With market rates rising above 1% recently, the worst may be over. However, rates remain at historic lows.

In response to the threat to investor confidence caused by variable Money Market fund behaviour, the IMA has agreed to adopt the European Securities and Markets Authority’s guidelines, and split the Money Market sector into two groups: Short-Term Money Market, and Money Market. Starting 1 January 2012, the two new IMA Money Market sectors reflect exactly the FSA Handbook regarding what should constitute a 'Money Market' fund. Essentially, the maturity of securities in Short-Term Money Market funds is capped at 397 days, with a weighted average of no more than 120 days. While the Money Market limit is 2 years and 12 months respectively. This should allow investors to choose more easily between funds that are constrained to holding very short-dated investments, and those holding longer-dated instruments.

Some funds that previously appeared in the Money Market sector will no longer qualify for either of the new sectors, without fundamentally changing investment approach. Without change they will be forced into the Sterling Corporate Bond sector. This may have an impact on asset allocation outcomes; at the time of writing* there are still a number of funds who have yet to declare their approach, and we are monitoring the situation closely as fund managers review their fund objectives. Advisers running portfolios should be similarly engaged. The IMA’s move is belated but welcome. The question 'is it safe?' may still be unanswered, but should lead to less painful outcomes.

Graham Bentley is Head of Proposition at Skandia.

*19th December 2011.