This is an extended version of the article that appeared in the October 2012 issue of Investment Advisor.
Good ol’ money-market funds—the ultra low-risk, pretty-much-the-same-as-cash-plus-a-dividend funds that offer investors liquidity and a respite from market volatility. They’ve been go-to funds for decades, but in recent years just about everything in the investment world has changed and money funds are no exception. It’s not that the funds themselves have changed; it’s the dynamics in the marketplace.
Money funds are still used primarily to reduce portfolio risk by limiting exposure to asset markets and to maintain liquidity. Regulations haven’t changed (yet) either. Rule 2a-7 of Investment Company Act of 1940 restricts the quality, maturity and diversity of investments by money-market funds, which may invest in commercial paper, repurchase agreements, short-term bonds and other money funds. Money funds are required to invest primarily in the highest rated debt and maintain a weighted average maturity of 60 days or less and invest no more than 5% in any one issuer, except for government securities and repurchase agreements. They seek to maintain a stable value of $1 per share and pay dividends to investors, which emphasize their relative safety.
Historically Low Yields
Returns on money funds are at zero and any improvement seems impossible in the near-term. This has driven some investors to FDIC-insured CDs and interest-paying bank accounts. Of course, these vehicles can be cumbersome and aren’t as liquid as money market funds, but with no immediate sign of higher interest rates and continued uncertainty around stocks and bonds, investors aren’t demanding as much liquidity as they have in the past.
Interest rates on money funds’ underlying investments have been just a whisper above zero for several years now, and many funds have been forced to shut because there’s no profit to be had. Many of the funds still operating waive or drastically reduce their fees just to avoid “breaking the buck.”
Thankfully, over their almost 40-year history, only a few funds have broken the buck. After the Reserve Primary Fund did so in September 2008 as a result of the Lehman Brothers bankruptcy, it became clear that the risks of investing in money market funds are real. Regulators have been talking about reforming the rules around money market funds, but have taken no real action, despite several warnings from those in the know.
In an April 9 article in The Wall Street Journal, Kristina Peterson and Michael Derby reported comments from Federal Reserve Chairman Ben Bernanke that highlighted his concern. At a conference, he said, “The risk of runs created by a combination of fixed net asset values, extremely risk-averse investors and the absence of explicit loss-absorption capacity remains a concern. Additional steps to increase the resiliency of money-market funds are important for the overall stability of our financial system.” He also said that the repo market, where dealers finance their bond-trading positions, is a source of concern. He suggested that if there were a default of another major financial institution, the repo market could be exposed to some serious risks. This was at least the second time the Fed chairman made such comments publicly.
In the May 2012 issue of PIMCO’s Viewpoint, Jerome Schneider, a fixed income portfolio manager at the firm, wrote, “We believe there are three ‘plumbing’ issues short-term investors should constantly monitor during 2012 and beyond, because they will likely affect the performance of their cash management portfolios. The operational and funding components of our financial system – repurchase, or “repo,” agreements, collateral posting and funding transactions of collateralized and uncollateralized natures – are now important indicators of whether investors can expect to bathe in the warm waters of liquidity or suffer from unheralded waves of credit risk or ebbs in liquidity.
“Repurchase agreements are usually over-collateralized borrowings in which the holder of securities sells the securities to an investor with an agreement to repurchase them at a fixed price on a specified date. In the [United States], recent efforts by the Federal Reserve and the Securities and Exchange Commission to review the inner workings of the repo markets and money market funds only serve to highlight the importance of these pipes of liquidity and credit creation. However, this is a truly global problem that needs consideration and action by investors and regulators alike.”
Some observers are concerned that fund companies are being compelled to reach for yield. On its own, a repo is a simple and straightforward transaction, as long as the borrower has the ability to repurchase the collateral. Repos can also be manipulated in a way that creates leverage for banks. One of the main reasons MF Global failed was so-called “repo-to-maturity” transactions, which extended the repurchase date far into the future, thus increasing the risk of the transaction. Repos also played a key role in the failures of Bear Stearns, Merrill Lynch and Lehman Brothers.
The risks realized by investors in the Reserve Primary Fund, which broke the buck after writing off debt issued by Lehman, could have been felt in other funds, and most certainly would have if the Lehman default would have resulted in a run on the shadow banking system. Redemptions from money market funds result in a drop in demand for commercial paper, which may prevent companies from rolling over their short-term debt and potentially cause a liquidity crisis. In such a scenario, if companies cannot issue new debt to repay maturing debt and do not have cash on hand to pay it back, they will default on their obligations and may have to file for bankruptcy. Thus, a run on money funds could cause extensive bankruptcies and a debt devaluation spiral.
Of course, we can speculate about how markets might react in any number of situations. Such thought experiments are certainly healthy. The point is, given the observable risks—to say nothing of the unknown risks that hide in the dark corners of the shadow banking system—combined with the fact that returns on money funds at historic lows, it would be wise to consider some alternatives.
Money Market Alternatives
Recently, our firm decided to expand our universe of “safe haven” funds. As a tactical asset manager, we rely heavily on such funds, especially during weak market conditions, when we rotate investors’ portfolios out of the stock market.
We looked at several alternatives and these four—two ETFs and two mutual funds—made our short list. The ETFs were more traditional, giving us more of a pure play fixed income assets; while the mutual funds were true alternative investments, offering non-correlated exposure to specialized asset classes within a relatively conservative, actively managed investment strategy.
iShares Barclays Short Treasury Bond ETF (SHV). SHV is a plain-vanilla fund that tracks the Barclays U.S. Short Treasury Bond Index, which measures the performance of Treasury securities that have a remaining maturity of one to 12 months. This is an attractive money market alternative because it avoids the underlying exposures that most traditional mutual funds have, including repos and other collateralized and uncollateralized transactions. And, of course, the ETF structure is a good way to maintain liquidity.
PIMCO Enhanced Short Maturity Strategy ETF (MINT). MINT, as described by PIMCO, “is an actively ETF that seeks greater income and total return potential than money market funds, and may be appropriate for non-immediate cash allocations. MINT will primarily invest in short duration investment grade debt securities. The average portfolio duration of MINT will vary based on PIMCO’s economic forecasts and active investment process decisions, and will not normally exceed one year. MINT will disclose all portfolio holdings on a daily basis, and will not use options, futures or swaps.”
The fund’s portfolio manager, the above-mentioned Jerome Schneider, is keenly aware of the risks that Bernanke and others have expressed. This fact offers some measure of confidence that he may be able to manage through bumps in the landscape.
We like that the fund seeks to outperform typical money market funds by owning longer maturity bonds and a broader universe of investment-grade fixed income securities. As the well-known leader in fixed income, PIMCO has always had talented portfolio managers and analysts. The ETF structure, which provides daily liquidity and full transparency, is also a positive.
Bishop Volatility Flex Fund (BVFVX). This fund takes a step out on the risk spectrum—a rather small step. The prospectus says that it holds 90% of its assets in U.S. Treasury securities; the other 10% of assets are used to purchase options on the S&P 500 Index.
The fund seeks to monetize volatility using a non-directional methodology that invests in option spreads. The objective is to preserve principle while generating upside return regardless of market direction. The Volatility Fund uses an unleveraged approach, simultaneously holding both long and short positions providing the potential to capture returns in both rising and falling market volatility environments.
This fund can be used as an alternative to money market funds or to add another level of diversification. Bishop says the fund was designed to act as a “shock absorber” for investors’ portfolios.
The fund is relatively low-risk and because it trades off volatility—market movement both upward and downward—the fund’s performance is neither positively correlated nor inversely correlated to other asset classes. In fact, the correlation numbers on this fund are excellent. It is uncorrelated to all of the asset classes we measured, including domestic and international stocks and bonds, real estate, currencies, commodities and managed futures.
Sarasota Capital Strategies Currency Strategies Fund (FOREX). Like the Volatility Fund, this fund is also more risky than traditional money market funds. It too is uncorrelated to most other asset classes, making it a good tool for portfolio diversification and reduced volatility, and has the potential to enhanced returns.
The currency markets are very dynamic, in part because currencies are valued relative to each other. If currencies are a zero-sum game, they must be traded in order to generate profits. The portfolio managers at Sarasota say, “The trading models with the most explanatory power are those that emphasize order flow in a multiple dealer, simultaneous trade market.” In other words, the supply and demand for currencies best explains exchange rate fluctuations. The best way to measure supply and demand is through technical analysis.
The portfolio managers run multiple, equally-weighted indicators that are diversified across time frame and strategy to achieve three main goals:
- Achieve low correlation to other asset classes
- Limit volatility (They target a standard deviation of less than 1% based on monthly returns.)
- Provide investors with an additional asset class for diversification and hedging purposes
It is impossible to accurately measure the risks of exposure to the U.S. shadow banking system, which may alone be a good enough reason to avoid it. But that doesn’t mean risk assessment can’t be done.
As the investment management industry continues to innovate, offering investors a vast array of alternative investment solutions, advisors should take the time to learn about how these alternatives can benefit their clients and their practice.
Interest in alternative investments has exploded in recent years because investors are demanding a greater emphasis on risk management. Investment managers and innovative fund companies are responding by creating products to meet the demand for greater diversification, reduced volatility and the potential of returns regardless of the performance of traditional asset classes.
Schreiner Capital Management has a portion of client assets invested in BVFVX.