The widely anticipated reforms for money market funds were due for implementation in October 2016, drastically changing the way investors and the affected fund providers view them as an alternative for short-term cash investing. Many investors, especially institutions, faced increased risks or lower yields on their short-term money, while fund providers reconsidered the worth of their offerings. With more than $2.7 trillion invested in money market funds, investors and providers alike had a lot at stake in the changes and how funds were managed. Although nominal for most individual or retail investors, for institutional investors and the fund providers, the changes required significant rethinking on the value of money market funds.
The Reason Behind Money Market Fund Reform
At the peak of the 2008 financial crisis, the Reserve Primary Fund, a large New York-based fund manager, was forced to reduce the net asset value (NAV) of its money market fund below $1 due to massive losses generated by failed short-term loans issued by Lehman Brothers. It was the first time a major money market fund had to break the $1 NAV, which caused a panic among institutional investors, who began mass redemptions. The fund lost two-thirds of its assets in 24 hours, and eventually had to suspend operations and commence liquidation.
Six years later in 2014, the Securities and Exchange Commission (SEC) issued new rules for the management of money market funds to enhance the stability and resilience of all money market funds. Generally, the new rules place tighter restrictions on portfolio holdings while enhancing liquidity and quality requirements. The most fundamental change was the requirement for money market funds to move from a fixed $1 share price to a floating NAV, which introduced the risk of principal where it had never existed.
In addition, the rules required fund providers to institute liquidity fees and suspension gates as a means of preventing a run on the fund. The requirements included asset level triggers for imposing a liquidity fee of 1 or 2%. If weekly liquid assets fell below 10% of total assets, it triggered a 1% fee. Below 30%, the fee increased to 2%. Funds also suspended redemptions for up to 10 business days in a 90-day period. While those were the fundamental rule changes, there were several factors investors needed to know about the reform and how it might affect them upon implementation.
Retail Investors Not Completely Affected
The most significant rule change, the floating NAV, did not affect investors investing in retail money market funds. These funds maintained the $1 NAV. However, they were still required to institute the redemption triggers for charging a liquidity fee or suspending redemptions. Many of the larger fund groups took actions to either limit the possibility of a redemption trigger or avoid it altogether by converting their funds into a government money market fund, which had no requirement.
The same cannot be said for people who invest in prime money market funds inside their 401(k) plans, because these are typically institutional funds subject to all of the new rules. Plan sponsors had to change out their fund options, offering a government money market fund or some other alternative.
Institutional Investors Have a Dilemma
Because institutional investors are the target of the new rules, they were the most affected. For them, it came down to a choice of securing a higher yield or higher risk. They could invest in U.S. government money markets, which were not subject to the floating NAV or redemption triggers. However, they had to accept a lower yield. Institutional investors seeking higher yields had to consider other options, such as bank certificates of deposit (CDs), alternative prime funds that invested primarily in very short maturity assets to limit interest rate and credit risk, or ultra-short duration funds that offered higher yields, but also had more volatility.
Fund Groups Must Adapt or Get Out of Money Market Funds
Most of the major fund groups, such as Fidelity Investments, Federated Investors Inc. (NYSE: FII) and Vanguard Group, planned to offer viable alternatives to their investors. Fidelity converted its largest prime fund into a U.S. government fund. Federated took steps to shorten the maturities of its prime funds to make it easier to maintain a $1 NAV. Vanguard assured its investors that its prime funds had more than enough liquidity to avoid triggering a liquidity fee or redemption suspension. However, many fund groups were still assessing whether the cost of compliance with the new regulations was worth keeping their funds. In anticipation of the new rules, Bank of America Corp. (NYSE: BAC) sold its money market business to BlackRock Inc. (NYSE: BLK) in 2015. Regardless of the approach any particular fund group took, investors expected a flurry of communications explaining any changes and their options.