June was a month of relative reprieve from the ongoing European fiscal drama. Favorable outcome in the Greek election combined with the agreement among Eurozone members to move toward an FDIC-like bank support model went a long way to soothing the nervousness that griped the capital markets at the beginning of June.
Of note during the month was SEC Chairwoman Mary Schapiro’s comments before Congress in which she advocated for the changes in the structure of money market funds, as recommended by the Volker rule. Specifically, she’s in favor of daily mark-to-market valuation of the Net Asset Value of the funds. As it currently stands, money market funds maintain straight line amortization/accrual of their bond holdings, thereby always maintaining a stable NAV of $1.00. The problem is that when the valuation of one or more of the fund holdings falls sharply, the fund is forced to abandon its steady NAV and mark the portfolio to market, an occurrence known as “breaking the buck.” “Breaking the buck” is usually a precursor to a run on the fund. A glaring example of such a run occurred in 2008 when The Reserve Fund was forced to suspend redemptions following the Lehman Brothers bankruptcy. In moving to a daily mark-to-market valuation, or floating rate NAV, the money market funds would experience daily performance variation and the “breaking the buck” issue would go away.
In addition to floating the NAV, Chairwoman Schapiro is a strong advocate of having the money market mutual funds hold back 3% of every fund liquidation for 30 days. The intention of the rule is to lessen the impact to the fund should a material percentage of fund investors decide to liquidate. From our perspective, the idea is badly flawed. Should a material percentage of investors decide to sell the fund at once, it’s likely a fundamental problem is at the root of the redemption and a 3% holdback would do little to resolve the problem. In the money market space a sudden drop in assets under management begets a run on the fund. A 30 day hold back would only exacerbate the run given that the first to redeem would be the first to get their remaining 3%.
During the testimony, Chairwoman Schapiro disclosed the rather surprising news that since 1970 there have been more than 300 occasions in which a mutual fund management company injected cash into their money market fund to avoid “breaking the buck.” Moreover, she characterized the $2.5 trillion dollar industry as having grown so large that the potential exists for a money market panic to destabilize the global financial system. From her comments, it’s clear to us that the money market mutual fund industry is not the riskless “mattress” that it has come to be viewed, but instead a threat that requires immediate attention. With regard to the two proposals, we’re in favor of the mark-to-market concept, but not the holdback. In moving toward marking-to-market, investors will come to understand that there is risk in their holdings and will be able to compare the riskiness of competing funds much as they do when comparing any other mutual fund. However, we think that the holdback idea is not a good one and simply attempts to protect poor portfolio management. Investors, both retail and institutional, consider their money market fund to be cash and are not going to be happy to learn that it’s only 97% cash.
While the effort has been in the works for some time, it now seems that the likelihood of implementation is growing. Despite the radical changes being discussed, it doesn’t appear that the investing public realizes that changes are afoot. It should be interesting to observe investor response. At the very least, we expect institutional investors to shift assets out of money market funds and into separately managed accounts.
Also of note during the month, the Bureau of Labor Statistics released the third and final version of first quarter GDP. While the report reconfirmed that economic growth for the period was 1.9%, it revised quarter-to-quarter aggregate corporate profit to a slight decline; the first decline in 12 quarters. Digging deeper, the report showed that the profit shortfall was driven, not surprisingly, by the problems in Europe. Domestically, corporate profits grew at a healthy 2.66% quarter-on-quarter, with all industry segments improving. However, profits generated from the rest of the world fell a worrying 11.7%, quarter-to-quarter. The question going forward is will that profit contraction prove transitory, and if not, how will it impact the equity market? Anecdotal evidence of economic weakness and the 5% appreciation of the dollar versus the Euro during the quarter don’t offer much hope for a bounce in European profitability in the second quarter. As we commence earnings season, we’ll be watching closely for clues.