In a new report entitled, "Rising Rates to Unleash $5 billion for US Money Fund Sponsors," Moody's Investors Service says U.S. money market fund managers can expect to double MMF revenues in the near future as the industry is poised to recover some $5 billion in fees. Written by Neal Epstein, Senior Credit Officer; Robert Callaghy, Senior Analyst; Ram Sri-Saravanapavaan, Associate Analyst; and Marc Pinto, the report finds that money managers are already reducing fee waivers as yields creep up and that trend will continue once interest rates start rising, as is expected later this year. They say that once rates rise 40-50 bps, incremental fee waivers will be all but eliminated. They also discuss the impact of the new money fund regulations on fees once they kick in in October 2016. (Note: Crane Data publishes expense ratios and information, including charged and incurred expenses breakouts and fee waivers in our monthly Money Fund Intelligence XLS.)

The Moody's report explains, "Under the accommodative monetary policy of the past several years, yields on US MMFs, which are required to maintain high levels of liquidity, have trended under 20 bps, but in 2015 rates have begun to rise. At such low levels of return, MMF portfolios have yielded less income than they cost to operate [sic], and fund sponsors have been forced to waive, reimburse, or absorb these costs, to ensure a positive net yield.... The cumulative effect of a negative net yield would be that an MMF's net asset value would eventually fall below the threshold at which it is allowed, under current regulations, to transact at one dollar, i.e., it would "break the buck.""

It continues, "The residual returns that investors in MMFs earn have declined to less than 3 basis points. The difference between a MMF's gross and net returns is its expense ratio, and ... the industry's dollar-weighted average of expense ratios declined to a low point of 13.1 bps in January 2015 from 43.6 basis points at the onset of the financial crisis. Portfolio returns also bottomed out in January, averaging 15.5 bps. Since then, portfolio annualized returns have increased 1.8 bps to 17.3 bps, allowing expense ratios to increase 1.5 bps and net returns to increase 0.3 bps -- an 80:20 division of the increase in performance between fund advisors and investors. Currently, 84% of the funds' gross returns are being paid out as expenses, up from 10% in at the end of 2007."

Moody's writes, "After yields on money market instruments declined in 2008, MMFs found that their historical expense ratios exceeded portfolio returns. As a consequence, they waived fees to maintain positive net yields." To illustrate the impact of fee waivers, Moody's cites Fidelity Cash Reserves as an example. "This retail prime fund is the largest MMF in the iMoneyNet database, with over $110 billion under management as of May 2015. As shown, incurred fees as a percent of average AUM have remained at the current level of 37 bps for five years. Expense reductions have increased to 13 bps currently from zero before 2011, and net (shareholders') returns have declined to 1 basis point in the past two fiscal years."

On the pending waiver unwinding, they say, "On a gross basis, we estimate that MMF sponsors could recover $5.0 billion of foregone revenue when portfolio yields increase 22.1 bps, and the need to reduce fund expenses passes. This compares with current MMF fund revenues of $3.8 billion, based on an average expense ratio of 14.6 bps. We believe that as MMF returns rise, fund income will be used, preferentially at first, to reduce fee waivers and then to increase yields for investors. If fund yields increase 40-50 bps, most incremental waivers should be eliminated, allowing average expense ratios to return to pre-crisis levels."

Moody's adds, "Historically, when MMF yields were much higher, fund managers waived fees as a competitive matter. Even before the financial crisis, MMF boards of trustees authorized fund managers to reduce fees below incurred levels (a benefit to investors) when gross performance lagged competitors, to ensure that net fund performance would remain competitive.... These expense reductions, which equate to foregone revenue to MMF sponsors and distributors, should be largely reversible once money market yields increase -- and presumably they will be reversed when monetary accommodation is unwound, as we have begun to see in 2015."

They explain, "We arrive at our 22.1 bps estimate by evaluating the increase in weighted average waived expense ratios since 2008 and multiplying the increase by the current level of AUM. Waivers were just 5.6 bps in 2007, increasing to 6.6 bps in 2008. After 2008, the waived expense ratio increased to 32.0 bps as of December 2013, and since has declined to 28.6 bps in May 2015... Currently, the incremental increase in the fee waiver since 2008 stands at 22.1 bps.... The incremental waiver based on today's weighted average fee rates and AUM is $5.8 billion, which we have rounded down to $5.0 billion, with the expectation that even with higher rates, expense ratios may not fully return to levels of 2008, given changes in the industry."

The Moody's piece says, "Our $5 billion gross estimate of increased fees is attributable to increases in both operational and distribution revenues, with somewhat more going for operations. Since some portion of fee waiver and expense reduction is borne by other service providers, the gross amount will be shared, leaving less for fund sponsors. It is challenging to estimate the shared amount since in many cases, transfer agents and distribution partners are also affiliated with the fund sponsors. Each element of the expense ratio total may be reduced to manage total expenses, and the manager or the fund distribution partners may bear some component of these reductions accordingly.... In 2015, the 2.2 basis point decline in waivers has been distributed 1.5 bps to operating costs and 0.7 bps to distribution costs, corresponding to $380 million and $220 million of increased revenues for these service categories."

It adds, "[C]ombined operating fee waivers have been the largest component and they have declined the most in 2015. It is here that we expect to see the greatest responsiveness of fee recoverability. Shareholder servicing fee waivers were the largest single component of the total expense waiver. 12(b)-1 (distribution plan) fees are the smallest component and they have varied the least since 2008." Moody's shows operating data from Federated Investors' earnings presentations over the last few years, which show that "distribution fee arrangements with third parties have reduced the revenue impact of waivers from 14 bps to 4 bps, a 71% reduction. Federated may realize less of a benefit from waiver reductions than other managers, who distribute funds through affiliated distributors. In the first half of 2015, Federated's gross annualized fee waivers declined $54 million, or 13%, versus calendar 2014, and on a net basis, annualized wavers declined $23 million, or 18%."

On the impact of new money fund rules, Moody's concludes, "We believe that new money market fund regulations, which take effect in October 2016, will have varying economic effects on fund yields and expenses, and thus on waivers. Of course, these effects would be greatly mitigated in a higher-return environment in any case. Reducing the need for waivers: 1) Floating NAV requirements for institutional prime funds will remove the technical requirement that these funds generate a positive return since they can no longer "break the buck." 2) Institutions' increasing interest in separate managed accounts would give rise to negotiated fees. 3) A broadening view of investors' cash management needs may cause them to use other, "ultrashort term" liquidity products, which could earn greater returns than MMFs, unconstrained by MMF investment requirements."

Finally, the piece adds, "Increasing the need for waivers: 1) The potential for exit fees or gates to be deployed for MMFs other than treasury and government funds (in the eventuality that weekly liquid assets were to fall below 30%) will cause these funds to be managed more conservatively. It follows that yield will decline in these funds, which will put greater pressure on their cost structure, increasing waivers and reducing profitability. 2) Investor substitution of lower-yielding government funds for prime funds would increase the need for operating waivers in a low yield environment, especially as increased demand for government funds, which many analysts anticipate, drives their yields even lower."

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