WHAT ARE MONEY MARKET FUNDS?

Money market funds are mutual funds that invest in short-term debt instruments.  They provide the benefits of pooled investment, as investors can participate in a more diverse and high-quality portfolio than they otherwise could individually.  Like other mutual funds, each investor who invests in a money market fund is considered a shareholder of the investment pool, a part owner of the fund.  Money market funds are actively managed within rigid and transparent guidelines to offer safety of principal, liquidity and competitive sector-related returns.

There are two basic types of money market funds: constant net asset value and accumulating net asset value.  Shares in constant net asset value funds are issued with an unchanging face value (such as US$1 per share).  Income in the fund is accrued daily and can either be paid out to the investor or used to purchase more units in the fund at the end of the month.  Accumulating net asset value funds, known alternatively as ‘roll-up’ funds, operate under the same investment guidelines as constant NAV funds and income is accrued daily.  However, unlike constant net asset value funds, income is not distributed.  Instead income is reflected by an increase in the value of the fund shares. 

Money market funds were first offered in the US in the early 1970s.  In 1983 the US Securities and Exchange Commission published regulations for money market funds, which acted to define and standardise the asset class.  The regulations, known as SEC2a-7, set detailed parameters governing credit, market and operational risk.

Now money market funds are widely used across the financial world in both the institutional and retail sectors.

Money market funds were first exported to offshore European centres in the late 1980s.  In the absence of SEC 2a-7 equivalent regulations, the market looked to the rating agencies to provide assurance on the quality of these funds.  The requirements applied to the funds by the rating agencies are broadly modelled on SEC 2a-7, but, for triple-A rated funds, the controls are more restrictive.  In addition, some funds operate within the parameters set down in UCITS legislation (Directive 85/611/EEC).

The principal providers of money market funds in Europe have formed a trade association, IMMFA.   IMMFA members adopted a Code of Practice in February 2003 that aims to ensure that members offer a high quality product and service to investors.  Click here to access a copy.  All IMMFA funds are triple-A rated by one or more of the rating agencies (such as Standard & Poors and Moody’s).  IMMFA funds also operate under the regulatory requirements of each fund’s domicile.

Money market funds have as their primary objective the preservation of capital.  Liquidity and competitive, sector related, returns are other key objectives.  The rating process methodically identifies, assesses and weights each fund in terms of its ability to deliver on these objectives.

The rating criteria broadly comprise four main areas of analysis that systematically address a fund’s operating principles: its credit quality, portfolio construction, fund management and regular post-rating inspection.  These are described in more detail below.

Credit quality

Credit quality is evaluated on three levels: what the fund can buy, who it can do business with (including the exact nature of business) and who it can appoint to keep its assets safe.  The rating criteria therefore stipulate the fund’s asset range and restrictions (such as quality, type and currency), acceptable counterparty risk (for all transaction based investments) and acceptable choice of custodian. 

Portfolio construction

The most complex part of analysing a money market fund is judging a fund’s sensitivity to changing market conditions and, therefore, gauging a measure of its ability to shield investors from adverse market swings.  All money market securities (rated or otherwise) are subject to price fluctuations – based on interest rate movements, maturity, liquidity and the supply and demand for each type of security.  Quantifying the cumulative effect of these is crucial to assessing overall portfolio performance. 

Capital preservation is expressed in terms of the stability or constant accumulation of the fund’s net asset value per share.  As such, both formats are scrutinised for potential deviation in the fund’s market value.  Determination of market value, or portfolio price exposure, starts with the examination of susceptibility to rising interest rates.  A critical component of this is the fund’s weighted average portfolio maturity (or WAM), which is specifically restricted by rating category.  IMMFA members’ funds, which are triple-A rated, must stay within a 60 day limit, an optimal level derived from portfolio stress testing analysis.  Other variables evaluated include instrument liquidity, index and spread risk, portfolio diversification, potential dilution of investor holdings and portfolio valuation.

Fund management

The rating process requires an assessment of a fund manager’s operations – in common parlance, the front, middle and back offices.  Key areas of interest are the fund manager’s level of experience, the stated investment objectives, portfolio management techniques, risk aversion strategies, operating procedures and internal controls, including disaster recovery.  Owing to the precision necessary in running a money market fund successfully, every aspect of the fund’s management must be able to withstand close scrutiny and demonstrate effective, ongoing integrity of operation. 

Portfolio inspection

Owing to the constraints of the rating criteria and the extremely low margin of error permitted at the level of fund valuation, rated money market funds are contractually obliged to supply all portfolios for periodic rating agency inspection: fund surveillance, as it is called.  Any infringement or potential concern is communicated to the fund and timely rectification is required.

BENCHMARKS

Money market funds use different benchmarks to compare the performance of funds, as demonstrated through short-term indicative interest rates. The main indices are those shown below:

LIBID

LIBID is the London Interbank Bid Rate.

LIBID is the rate at which banks take deposits from each other. It is normally one eighth of a percentage point lower than the LIBOR (the London Interbank Overnight Rate – the rate at which banks lend to each other). LIBOR is calculated daily by the British Bankers’ Association (BBA), and whilst the BBA does not compile indicative LIBID rates, historic LIBOR rates can be found at http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=141&a=627.  

SONIA and EONIA

SONIA is the Sterling Overnight Interbank Average.

SONIA is the weighted average rate of all unsecured sterling overnight cash transactions brokered in London between midnight and 4.15pm with all counterparties in a minimum deal size of £25m.

EONIA is the Euro Overnight Interbank Average.

EONIA is the weighted average rate of all unsecured Euro overnight cash transactions brokered in London between midnight and 4.00pm with all counterparties.

SONIA and EONIA are weighted average overnight deposit rates for each business day. Both indices are published at 1700hrs each day.

Details of daily SONIA and EONIA rates can be found at http://www.wmba.org.uk/indices.php.