In the face of a negative interest rate environment and regulatory uncertainty in Europe, Northern Trust launched a variable net asset value money market fund in November, the Euro Liquidity Fund. (See our Nov. 6 "Link of the Day," "Northern's New Euro VNAV MMF.") Northern also recently held a webinar, "Why Returns Should Matter for Money Market Investors," featuring Wayne Bowers, CIO, EMEA and APAC, and David Blake, director, International Fixed Income, to discuss the possibilities and pitfalls of the shifting money market landscape and to explain why they launched a VNAV euro MMF. We review Northern's recent move and comments below, and we also quote from yesterday's Wall Street Journal article, "European Money-Fund Managers Brace for Losses".
Bowers said there are three main threats to the MMF industry in Europe. The first is regulations, which will directly impact the MMF industry in Europe and will most likely result in the adoption of VNAV funds, similar to the rules adopted in the U.S. The second is banking regulations, which will affect the prime instruments that have historically been used by money market funds. The third is negative interest rates, which threaten the constant NAV nature of a traditional money fund, explains Northern.
"Our view is that we will see sovereign QE from the ECB, most likely in the first quarter of next year," added Blake. "The most important piece as it relates to euro money market funds is that injection of liquidity is going to lead to lower and lower rates." That, in turn, will have an effect on yield, Blake said, which leads to a key question -- "Are fund managers altering risk profiles to maintain a positive yield? We worry that the threat facing money market funds -- negative interest rates -- are at risk of changing manager behavior. We go back to the basics and remind ourselves what the core principles of MMFs are -- principle preservation, liquidity management, and yield maximization, in that order. But with all that's going on with the structure of CNAV money market funds [and] their inability to handle negative rates, we're worried that yield maximization is actually creeping up."
Blake continued, "There is an opinion that we hear voiced from time to time that money funds are a commoditized product, but we reject that. We don't believe that money funds are all of equal risk, and to understand why that is, investors must look into the risk profile. The primary risk metrics within money market funds are based around duration, credit selection, and liquidity levels." However, he added, the game has changed in recent years. "The idea of being able to anticipate central bank changes and position the portfolio for the advantage of your clients has all but been taken out of the portfolio managers' toolkit. Credit risk is really the only tool that PMs have left to add to return with their money market fund.... In the current environment, more yield means more risk -- there's no way around that. Therefore we conclude that money funds are not a commoditized product and that investors should examine carefully the embedded risk within them."
"The return environment is clearly challenging for all investors, including money market funds. Our view is clear: we don't compromise your money fund allocation, but we do recognize that every basis point counts," said Blake. Thus, Northern employs a cash segmentation strategy with its clients. "We suggest, when possible, that clients look to split cash allocation across two or more buckets. Each of those buckets has a different purpose, a different risk profile, and a different return profile." They suggest Operational Cash, a defensive asset allocation to cover short-term spending needs; Reserve Cash, medium term cash allocation for intermediate or uncertain spending needs, and Strategic Cash, a longer term allocation for a traditional fixed income product. "This provides higher yielding overall portfolio allocation but it does so in a risk-controlled manner -- so your money fund is doing exactly what it should do -- preserving capital and maintaining liquidity. You can complement that with a high yielding strategy and take the risk in the appropriate place," he adds.
Finally, they discussed VNAV and the future of money market funds. Given the direction of interest rates and the regulatory environment, Northern had been considering for a while the idea of launching a VNAV euro MMF, explained Bowers. "We saw the potential for the ECB monetary policy to go from zero to negative, which would mean that the high quality assets used in money market funds would be negative yielding. So we knew that the CNAV structure would be, and is, fundamentally flawed when rates turn negative. The core principals of a money market fund demand an alternative structure. Our goal was not only to take a long term solution, but also listened carefully to our clients and what they wanted," he said.
"It seemed to be quite obvious that the VNAV structure would be preferred by our investors over the alternatives," Bowers added. "The need for cash management won't ever go away. If you look forward, the need for a VNAV structure is quite obvious. It not only makes sense today from the negative interest rate environment, but also in the future when you look at regulatory change." They expect reforms to be passed within the next 18-24 months and the negative interest rate environment to prevail for the foreseeable future.
When asked to explain the difference between the CNAV and VNAV structure, Blake said there are no differences except one. "What is changing is the accounting methodology, the idea of being able to move to a variable NAV specifically to cope with negative interest rates. We're not changing our portfolio management, we're changing the accounting methodology," he explains.
Finally, in the Q&A portion, Blake was asked why Northern is adopting a VNAV when the rest of the market seems to be maintaining the CNAV. "CNAV with the cancellation of units, or with a reverse distribution mechanism, is essentially a structure where the price of the fund remains at 1.00, but it seeks to deal with the negative interest rate environment by the forced cancellation or the forced redemption of investors' shares or units in the fund," said Blake. "A VNAV will vary based on the underlying market movements. It's exactly the same economic outcome. The reason we like VNAV is threefold: our clients prefer it, we feel it is a more transparent structure, and thirdly we have some technical concerns around CNAV with unit cancellation."
In other European MMF news, yesterday's Wall Street Journal featured, "European Money-Fund Managers Brace for Losses." The article says, "Some of the world's biggest money managers are making sweeping changes to their European money-market funds as a negative interest rate makes it unprofitable to run the investments. The moves by BlackRock Inc. and Northern Trust Corp. stem from the European Central Bank's decision in September to cut one of its interest rates into negative territory. The rate cut threatened the profitability of the E93 billion ($116 billion) industry of euro-denominated money funds, which are used by large corporations and institutional investors as a place to park cash while earning a small amount of interest."
The Journal piece quotes Crane Data's Pete Crane, "You can presume every euro money market fund out there already has something in place to deal with this scenario, or they've given the money back already." It adds, "The shift complicates options for money-fund clients, who already are struggling with where to put cash denominated in euros as some banks now are charging to hold such deposits on the back of the September rate cuts. This is the first time that a major market for institutional money funds -- considered to be the dollar, the sterling and the euro -- has experienced this sort of widespread rate challenge, money-fund managers said.... Fund managers draw a distinction between negative yields stemming from rate cuts and losses that occur because the instruments they invested in have declined in value -- a taboo prospect referred to in the industry as "breaking the buck.""
Finally, it concludes, "Companies might not see a giant exodus, even if all funds begin yielding negatively, because of the lack of other appealing options. Fund managers say euro funds generally cost investors less money than they would lose by keeping their cash at banks. Indeed, industrywide, assets in euro funds have fluctuated on a daily basis, but assets under management have increased E6.8 billion since the end of August through mid-December, according to Crane Data. "The view is, this is their best alternative,” says Dave Fishman, co-head of Goldman Sachs' global liquidity business.""
