The Independent Adviser, a newsletter covering Vanguard funds, discussed money fund fee waivers and the possibility of fee "recapture" in a recent story, "Vanguard's Million-Dollar Decision is the Industry's Billion-Dollar Problem." Editor Daniel Wiener writes, "Vanguard is facing a multi-million dollar decision. Its competitors are facing the same decision, but for them it's measured in billions. The decision: To allow money fund yields to rise as the Fed begins raising interest rates, or to begin paying themselves back for years of self-imposed fee waivers. You can be sure that fund marketers at Vanguard and elsewhere are debating the merits of "Which comes first, the chicken or the egg?" right now.... First, around the middle of 2009 Vanguard began to waive certain operating expenses on its money market funds. Vanguard called these "temporary limits" on some expenses but the bottom line is the bottom line. Vanguard was cutting back on expenses to make sure money market yields stayed above zero. At first they didn't disclose the numbers but over the past couple of years the level of these fee waivers has been disclosed in the footnotes to its money funds' semi-annual and annual reports."

The article goes on, "Over the most recently-reported six months Vanguard waived a bit less than $9.2 million on Prime Money Market, a fund with approximately $131 billion in assets (at the time of the waiver). Now, take a look at Charles Schwab's Cash Reserves money fund, with a bit less than $40 billion in assets. Schwab waived $87.7 million to "maintain a positive net yield" as they write in the fine print of their semi-annual report. This makes Vanguard's waiver look like chicken scratch. One thing you won't see in Vanguard's filings, but you do at Schwab (and they aren't alone) is language giving the company the ability to claw back waived fees. To give you a sense of the magnitude of this potential windfall, Schwab says that between 2014 and 2017 it has the right to recoup as much as $522.2 million in fees. These are called "reimbursement payments." Will they take them? Probably not. But the option is there."

Wiener explains, "Now, here's the money market conundrum for the entire industry: When interest rates finally begin to rise, and yields on the short-term bonds and commercial paper and other securities that Vanguard and its peers invest their money market assets in begin to rise as well, will fund operators cut back on the waivers first, or keep the waivers in place while allowing their money funds' yields to begin rising? ... Right now, with most money fund yields anchored at 0.01% there's little to distinguish one fund from the next. But that's bound to change. Imagine a scenario where the Fed begins hiking rates, money-fund securities begin paying higher yields and Vanguard uses those higher yields in the market to quickly reduce or eliminate its waivers. Will other fund companies follow suit? If they try to reduce their waivers their yields will remain stuck at 0.01% while Vanguard's will begin rising. Or, fund companies could keep their waivers in place and try to bump their money fund yields in an effort to stay competitive."

Money market fund managers waived $5.8 billion in fees in 2013, a record number up from $4.9 billion in 2012, and $5.1 billion in 2011, according to the Investment Company Institute. Since 2009, a total of $23.9 billion in money market fees have been waived. Money market fund advisers increased fee waivers to ensure that net yields (the yields after deducting fund expense ratios) did not fall below zero in the low interest rate environment. At the end of 2013, 99% of money fund share classes had waived at least some expenses. Historically, money market funds often have waived expenses for competitive reasons. For example, in 2006, $1.3 billion in fees were waived and 62 percent of money market fund share classes waived at least some expenses, according to ICI's study.

With the expectation that the Federal Reserve will begin raising interest rates in 2015, some money fund advisors will reduce or eliminate fee waivers as yields increase. However, given the billions in waivers over the last 5 years, some advisors will seek to recapture some of the lost revenue. Some fund companies have included language in their prospectuses that gives them the ability to recapture lost fees. Schwab is one, Oppenheimer is another.

In its money market fund disclosure, Schwab states: "In addition to the contractual expense limitation discussed in the prospectus, Schwab and the investment adviser also may voluntarily waive and/or reimburse expenses in excess of their current fee waiver and reimbursement commitment to the extent necessary to maintain a positive net yield (in the case of Schwab U.S. Treasury Money Fund, Schwab Treasury Obligations Money Fund, and Schwab Government Money Fund, a non-negative net yield). Under an agreement with each fund, Schwab and/or the investment adviser may recapture from any fund or share class any of these expenses or fees they have waived and/or reimbursed until the third anniversary of the end of the fiscal year in which such waiver and/or reimbursement occurs, subject to certain limitations. These reimbursement payments by a fund or share class to Schwab and/or the investment adviser are considered "non-routine expenses" and are not subject to any net operating expense limitations in effect at the time of such payment. This recapture could negatively affect a fund's future yield."

In other news, Fitch Ratings released, "The Fed's RRP Program: Where's the Money Coming From?" Fitch writes that since the launch of the Federal Reserve Bank of New York's overnight reverse repurchase exercise a year ago, investments by money market funds in RRP have climbed from $45 billion on September 30, 2013 to a peak of $275 billion on June 30, 2014. Writes Fitch, "The Fed's interest in using RRP as a monetary policy tool has prompted considerable interest in the question of how big the RRP program could eventually become, and where the new RRP money is coming from."

Fitch sees a shift to RRP from European Banks. "Government and prime money funds have consistently been the primary RRP investors since the start of the exercise, and they have accounted for 75% of RRP volume on average. MMFs have re-allocated investment balances to RRP from other short-term asset categories, in particular European bank certificates of deposits (CDs), time deposits (TDs) and repurchase agreements (repos). Smaller reallocations from other short-term investments have also occurred."

Further, "Fitch Ratings' analysis of MMF asset shifts since the start of the overnight RRP exercise (based on Crane Data LLC data) indicates that the rise in RRP allocations by money funds has been accompanied by consistent quarter-end declines in allocations to European bank CDs, TDs and repos. The quarter-end declines in European bank borrowings, while small in relation to balance sheet totals, may reflect increased investor focus on European bank leverage. At present, average metrics are rarely reported, especially in quarterly statements; but beginning in 2015, the banks will be required to report the European equivalent of Basel III leverage and liquidity coverage ratios on an average basis, helping to enhance investor insight. No significant shifts in allocations out of other asset categories, including short-term US bank instruments, Treasury and agency securities, or commercial paper, were evident in the MMF data."

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