The Securities Litigation Expert Blog

Money Market Fund "Liquidity"

Posted by Jack Duval

Dec 22, 2016 8:16:00 AM

This blog post continues a series looking at liquidity in common investments such as ETFs and mutual funds.  See previous posts on high yield and the Third Avenue Focused Credit Fund.

Greek Bank Run.jpg

Bank run at the National Bank of Greece                                 

Background

As the banks and brokers/dealers have reduced their risk appetites (and balance sheets devoted to market making/inventory) liquidity has shifted to investment funds.

This shift has occurred during a globally coordinated central bank easing/asset purchase cycle heretofore unknown in financial history.  Liquidity has not been needed because all assets (with the exception of volatility) have risen in price.

When asset prices fall, liquidity will be needed again.  With the banks and broker/dealers less willing to buy, liquidity will be at a premium.  It will be a buyers market and prices will have to fall further to entice liquidity back into the markets.

As will be explored, the potential for suspended redemptions is very real, often in places where investors least expect it.

Money Market Funds - Your Money is Safe with Us (from you)

Most investors would be surprised to learn that their money market fund has a "gate" just like a hedge fund.  Yet that is the case with the vast majority of money market funds.  In addition to a gate, most money market funds also have the ability to charge a one or two percent fee for investors to redeem their shares, if certain conditions are met.

Vanguard Prime Money Market Fund

The Vanuard Prime Money Market Fund is the second largest in the world.  Here are some excerpts from the prospectus that might surprise its investors (emphasis added):

You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the Fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

Emergency circumstances. Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days. In addition, Vanguard funds can suspend redemptions and/or postpone payments of redemption proceeds beyond seven calendar days at times when the NYSE is closed or during emergency circumstances, as determined by the SEC. In connection with a determination by the board of trustees, in accordance with Rule 22e-3 under the Investment Company Act of 1940, a money market fund may suspend redemptions and postpone payment of redemption proceeds in order to facilitate an orderly liquidation of the fund. In addition, in accordance with Rule 2a-7 under the Investment Company Act of 1940, the board of trustees of a retail or institutional money market fund may implement liquidity fees and redemption gates if a retail or institutional money market fund's weekly liquid assets fall below established thresholds.

 Discretionary liquidity fee. The Fund may impose a liquidity fee of up to 2% on all redemptions in the event that the Fund’s weekly liquid assets fall below 30% of its total assets if the Board determines that it is in the best interest of the Fund. Once the Fund has restored its weekly liquidity asset to 30% of total assets, any liquidity fee must be suspended.

 Default liquidity fee. The Fund is required to impose a liquidity fee of 1% on all redemptions in the event that the Fund’s weekly liquid assets fall below 10% of its total assets unless the Fund’s Board determines that (1) the fee is not in the best interest of the Fund or (2) a lesser/higher fee (up to 2%) is in the best interest of the Fund.

 In addition to, or in lieu of, the liquidity fee, the Fund is permitted to implement temporarily a redemption gate (i.e., suspend redemptions) if the Fund’s weekly liquid assets fall below 30% of its total assets. The gate could remain in effect for no longer than 10 days in any 90-day period. Once the Fund has restored its weekly liquidity assets to 30% of total assets, the gate must be lifted.

I am not picking on Vanguard, every money market fund (with the exception of some government money market funds), has identical language in their prospectuses.

Suitability and Alternatives to Money Market Funds

In light of the liquidity risks to holding mutual funds, it is not suitable for investors to hold all of their cash equivalents in money market funds.  Instead, investors should hold three-month Treasury bills and just roll them four times a year.  They will have a lower yield than the money market funds, but this is trivial compared to a suspension of redemptions or a two percent haircut on the proceeds.

Litigation

While the losses from a one or two percent redemption fee are limited, the secondary effects of preventing clients from making investments they otherwise could have made, will be considerable.

Supervision

Supervisors at banks and broker-dealers should make sure their advisors are aware of the potential gates and liquidity fees and encourage diversification out of money market funds.

Complexity Risk

While money market funds have traditionally been less complex than other investments, the new regulations have changed that.  As we have discussed here, here, and here, investment complexity is a frequent destroyer of capital.

For money market funds, investors can be harmed by market events unrelated to the money market fund they hold.  For example, a Bloomberg stress test on the Vanguard Prime Money Market Fund shows that another Russian Financial Crisis would hit the fund's P&L for 1.32 percent.  This is enough to break the buck and/or require the fund to close the gate or implement liquidity fees.

Vanguard Prime MM - BBG Stress Test.gif

If you think this is an extreme event, consider that it is merely a "18-year storm".

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Notes:

 For information about securities expert Jack Duval, click here.

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Topics: suitability, Complexity Risk, Money Market Funds, supervision, Complex Investments, Liquidity

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