Last week, a research paper written by Larry Locke, Ethan Mitra, and Virginia Locke from the University of Mary Hardin-Baylor College of Business was published in the Clute Institute's Journal of Business & Economics Research. Entitled, "Harnessing Whales: The Role of Shadow Price Disclosure in Money Market Mutual Fund Reform," the paper "indicates that the SEC's shadow price disclosure regime has no greater impact on institutional investors than on retail investors, and with no discernible distinction between funds with shadow NAV's under $1 versus over $1," we're told by author Locke. He says, "This seemed interesting to us given both the SEC's and FSOC's continued interest in using shadow price reporting as a means to coopt institutional investors into disciplining money fund advisors, and some fund firms' introduction of daily shadow price disclosure. We also took the opportunity of writing on the topic to discuss some of our views on the reform efforts currently underway."
The paper's "Abstract" explains, "The money market mutual fund industry is experiencing a sea change. Thanks, in large part, to their role in the 2008 market break, U.S. securities regulators have targeted money market funds for a structural overhaul. Runs on money market funds by institutional investors in the wake of the Lehman Brothers bankruptcy weakened the short-term credit market to the point of collapse. The resulting intervention of the Federal Reserve and the Treasury may have saved the economy from further damage but came at such a perceived cost that legislation now forbids it. Both the Securities and Exchange Commission (SEC) and the Financial Stability Oversight Council (FSOC) believe restructuring is necessary. Their only question appears to be exactly what form the product will take."
It continues, "One of the elements being considered in the reform effort will be increased disclosure of money market fund shadow prices. The regulators have posited that more frequent and more available disclosure of fund shadow prices will lead to more discipline being exerted on the fund industry, especially by the institutional market. A revamped disclosure regime, however, has been in effect since monthly shadow price disclosures were imposed by the SEC in December 2010."
Locke's Abstract adds, "This study looks at the impact of those 2010 disclosure regulations on different sectors of the market. It seeks to identify a correlation between shadow prices and changes in assets for both retail and institutional funds. The authors assess the findings of the study and discuss the implications of those findings for the impending regulatory restructuring."
The paper's "Introduction" tells us, "Money market mutual funds have been a favorite of both institutional and retail investors for decades. From their origins in the 1970's, money market funds grew to $3.8 trillion in 2008 before declining to $2.69 trillion as of year-end 2011 ("2012 Investment Company Fact Book", n.d.). They invest exclusively in short-term, highly rated securities, minimizing both interest rate risk and credit risk ("Frequently Asked Questions About Money Market Funds", n.d.). Money market funds are a peculiar form of mutual funds registered with the SEC under the Investment Company Act of 1940. While most open-ended registered investment companies sell and redeem their shares at the next determined net asset value, money market funds are permitted by Rule 2a-7 under the '40 Act to issue and redeem shares at the fixed price of $1 per share."
It continues, "Their substitutability for commercial bank checking accounts probably has contributed to their popularity. Unlike bank accounts, however, money market mutual funds are uninsured and investors in money funds are, in fact, exposed to the risk of the funds' underlying investments (Waddell, 2012). A money market fund is only permitted by Rule 2a-7 to sell and redeem shares at $1 if it maintains a true net asset value per share (or shadow price) within one half of one cent of a dollar (Rule 2a-7(c)). If the shadow price deviates from $1 by more than half a penny, the fund is required to take immediate measures such as liquidating the fund or allowing its share price to float with the NAV (Rule 2a-7(c)(8)(ii)(B)). Only when a money fund "breaks the buck" will investors be exposed to losses imbedded in the fund. `Fortunately for investors, breaking the buck has been a historically rare event. Between the 1970's and 2008, only one money market fund had ever broken the buck (Mamudi, 2008). Investors may have understandably assumed that money funds were a safe and liquid place to invest short-term funds."
The study says, "In 2012, two of the authors published a study showing that there was no statistical correlation between published money fund shadow prices and investor activity with respect to aggregate buying or selling of shares of those funds (Locke, 2012). The lack of correlation found by the study was significant because, as discussed above, the SEC's stated purpose for the new requirement that funds disclose their shadow prices monthly was to encourage the market to discipline fund managers. The 2012 study indicated that investors generally were not responding to the published shadow prices and, therefore, the SEC's regulatory purpose was not being fulfilled, despite the industry's compliance."
It adds, "Two questions that arose after the 2012 study was published were whether the sample in the 2012 study was sufficient and whether institutional investors might behave differently than the market overall. The sample for the 2012 study was necessarily small because the funds had only begun to report their shadow prices monthly in December 2010. Although the sample for the 2012 study amounted to approximately 30% of the industry's total assets, the study could only measure activity through August 2011 (Locke, 2012). Industry observers also suggested that the overall lack of correlation between shadow price performance and investor activity might have been masking a potentially significant correlation between shadow prices and institutional investor behavior. Because the 2012 study did not differentiate between retail and institutional funds, the behavior of institutional investors was indistinguishable from the behavior of the market overall. The current study has sought to answer both of these open questions."
The study concludes, "There appears to be various levels of disconnect in the relationship between shadow price reporting and the current regulatory reform efforts. In 2010, the SEC created a new reporting regime designed to impose discipline on money fund managers. The study indicates that imposition is not currently effective for either retail or institutional funds. Securities regulators have the option to either accept that lack of correlation as a reality of investor behavior or they can seek to increase the disclosure, or impose other financial incentives, in order to achieve the level of market discipline they seek. Current indications are a preference for the latter. At the same time that regulators are discussing the options, major market players have moved forward offering the most extreme level of shadow price reporting that either the FSOC or the SEC has considered. It is a surprising move on their part and seemingly out of sync with the past negotiations between the industry and the regulatory community over the future of the product."
It says, "Another disconnect in the current situation may be one of the underlying premises of the regulatory effort. The focus of regulatory thinking has been on restructuring money funds so that investors would not have an incentive to "run" on money funds because of the disruption and potential risks funds face when assets decline precipitously (Patterson, 2012). That focus could be subject to question as it was arguably not the run on the funds that ultimately required government intervention, but rather the funds' own retreat from the commercial paper market."
Finally, Locke adds, "The lack of correlation that continues to be found between shadow price reporting and investor activity highlights the complexity of the relationship between this market and its regulatory superstructure. As those responsible for regulatory policy, and those responsible for directing the industry, continue to seek a new model for the money market mutual fund product, they would be well served to consider the effects on the investor community, the market overall, and an industry that has served both with distinction for the last four decades."
