Money fund due diligence is among several topics du jour with corporate investors. Prior to the Reserve Primary Fund “breaking the buck” in September 2008, loss of principal and liquidity in a money market fund was barely a concern for most corporate cash investors. Much has occurred in the fund industry since then, and the investing public should no longer count on the government to be the knight in shining armor. We believe, it is now crucial that investors have due diligence methods to critically evaluate the risks of money fund investing.
Unfortunately, few options are available for the typical corporate investor. In retrospect, few, if any, of the traditional measures, from credit ratings to portal reports to fund commentaries, proved completely effective in avoiding funds like Reserve Primary. The knowledge of a particular fund’s characteristics such as its weighted average maturity (WAM), average credit rating, and exposure to specific asset classes seems no more helpful, since funds with a few similar characteristics may still have significantly different risk profiles.
As a regular part of the investment process at Capital Advisors Group, we evaluate the creditworthiness of money funds in our portfolios routinely, and often are faced with the same challenge. Due to our liquidity mandate for cash portfolios, prime money funds often represent our largest credit concern. With no suitable off-the-shelf solutions, we set out to several years ago to develop a practical, intuitive and effective fund evaluation tool for ourselves.
What Does “Risk” Mean in a Money Fund?
First, it is important to understand exactly what risks we are trying to identify, avoid or minimize. In simple terms, the myriad of risks associated with a typical fund can be reduced to two items: the loss of principal when a fund breaks the constant dollar share price and the loss of liquidity when fund management decides to halt redemptions. While credit risk is generally well understood and feared, liquidity risk often can be a larger threat to investors – and may be too often overlooked. Furthermore, these two risk factors can often be intricately related.
It is not difficult to argue why liquidity risk management is more critical than managing credit risk, although both are important. We think the previous version of SEC Rule 2a-7 already did a reasonably good job in limiting portfolio credit risk, so much so that shareholders of the Reserve fund are now expected to lose no more than 1.25% of principal* lehman-debt-update1-.html). On the other hand, having lost access to an asset pool designed for day-to-day usage can be devastating and potentially deadly to a company if alternative liquidity is not readily available. History shows that when a fund is forced to halt redemptions, it often ceases to be a going concern and enters into an unwinding process that may take weeks or months. It is for this reason that our own money fund due diligence process focuses heavily on several liquidity risk factors.
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