Money Market Funds: CNAV, LVNAV & VNAV

How do you diversify cash across dozens of high-grade issuers, with guaranteed same-day access, without building an investment management operation? For corporates, Money Market Funds (MMFs) are the most common solution. They are a genuinely worthwhile alternative to bank deposits.

But like the banking industry, MMFs have had some spectacular failures. Most notably in 2008 when the Reserve Primary Fund "broke the buck" (i.e. the Net Asset Value of $1 invested fell below that price) and in March 2020 when prime funds needed central bank support to meet redemptions.

But like the bank failures, the response from regulators has led to more scrutiny and significant tightening of rules, leading to more robust frameworks, and more protection for investors.

What you're actually holding

MMFs invest in a wide range of high quality, short term assets including government bills and bonds, supranational and agency debt, bank deposits, repo and corporate bonds, with strict limits on maturity (weighted average life, and individual security maturity limits) and concentration.

Diversification without the effort is the main selling point. No single issuer failing dents you badly, which is a materially different risk shape from a deposit's single-name exposure.

In return you hold a different risk profile. The fund risk lives in the structure type and the liquidity rules. Floating returns, the possibility of getting back (slightly) less than initially invested, and limits on how much you can withdraw over a given period.

Categories

Under the EU's money market fund regulation, money market funds fit in 3 broad categories:

In the US, the options are:

Fees & charges

Fees for Money Market Funds are typically lower than other managed investment portfolios and are taken out of investor returns rather than charged upfront or on exit.

Large institutional funds have a total expense ratio (fees as % of NAV) of between 10 and 25bps per annum. Smaller and retail focused funds can be 40-50bps more expensive.

Redemption gates and liquidity fees: it's for your own good

Following rule changes in 2008 and 2020, regulators recognised that a stressed sale wasn't in the investor's best interests. Since then, every MMF's documentation permits:

All of these conditions are designed to prevent every minor panic from turning into a run for the exits consuming liquid assets at remaining holders' expense.

Liquidity fees are typically used to ensure the cost of a large liquidation is borne by the investors making the withdrawal, rather than those remaining in the fund. For example, if a large redemption forces sale of assets at a wider bid-offer spread than usual, that cost is taken from the redeemed funds rather than being absorbed by the fund (i.e. remaining investors). These are typically single or small double digit basis point charges, but could be 1% or more in an extreme stress scenario.

What does diversification across managers get you

It is important to understand what you are diversifying, and what you aren't.

A single MMF already gives you diversification away from single name to a wide portfolio of assets and names.

Diversification across multiple managers gives you some protection against manager specific risk, operational risk (a single administrator or custodian failing, dealing platform outages etc), portfolio construction risk (funds broadly invest in the same universe, but will have different weights and different specific assets).

What you aren't protected from is systemic market risk. No matter how many Government NAV funds you invest in, if US Treasuries experience a genuine liquidity or confidence crisis, all of your funds will be affected in the same way. In a similar vein, in 2020, when Covid broke out and global trade ground to a halt, corporate investors withdrew funds en-masse to shore up their liquidity. All funds were affected in the same manner.

What happens when rates turn negative

The period between 2014 and 2022 in Europe proved a challenge for MMFs and an interesting case study. While the period didn't incur any mass liquidations or bail-outs, it did challenge the fee model and investment thesis of many funds.

In the absence of any positive returns from which to subtract fees, managers had to subtract fees on top of already negative rates, exacerbating the pain for investors.

Some chose to reduce rates, or delay charging negative rates, while some more expensive retail funds were forced to close entirely and return funds to investors as their model became uneconomic.

Another common response was that many investment managers shifted their investment profile. Investing in longer term or slightly riskier assets in order to minimise the negative returns. This was done within the bounds of the existing credit, maturity and liquidity rules of the funds, but it is worth being aware of. Keep an eye on your portfolio composition and ensure you remain comfortable if the composition drifts.

The practical protocol is to spread your investment across two or three funds from different managers, check the regular liquidity disclosures monthly or quarterly, and read the factsheet's portfolio breakdown, so you know whether your fund carries government, bank or corporate paper. Ten minutes of work annually carries a lot of value when the day comes that someone finally has to ask you about it.

Bank accounts vs MMF features, strengths and weaknesses:

Key takeaway

For mid-sized corporates an MMF occupies a unique position combining some of the advantages of bank deposits such as daily liquidity, easy administration and relative price stability, with features that bank deposits can't provide, including broad diversification, professional management and enhanced transparency. This is the reason MMFs have become the primary investment vehicle for corporate treasurers looking for a home for cash beyond their bank relationships.