Money Fund Stress Testing Lessons
Investor Analytics authored an article, "Riskology: What money markets can teach hedge funds." IA's Damian Handzy writes, "Hedge funds have regularly been at the forefront of innovation when it comes to investing strategies, alpha generation, asset class creation and risk management. Part of that innovation comes from adopting practices and analysis from other fields, and it is in that spirit that I claim hedge funds can benefit from understanding the practices of an investment vehicle they themselves use for cash management: money markets. Recent updates to the regulations governing these funds are directly applicable to hedge fund risk management, and offer improvements in ways to manage liquidity risk and perform simultaneous stress tests.... Among the new regulations was a set of stress tests that closely resembled what some of our hedge fund clients had been doing for years, but these stress tests required simultaneous multi-dimensional stresses. Specifically, they require the funds to stress interest rates, credit spreads and liquidity/redemption requests to the point of breaking the buck, defined as not being within 0.5% of the target $1 price. Their logic is sound: unless you actually go to the breaking point, how can you know how safe or how much danger your fund is in? This is a very engineering-like approach, in which a sample material is tested to its physical breaking point to ensure that the force required to break it is well outside the expected real-life load. With money market funds, they are required to simulate how the combination of rates, spreads and redemptions might bring their fund NAV to below the point of breaking the buck. While they are required to stress each of those dimensions separately, the more realistic stresses are those that simultaneously move the three dimensions to see what combinations of interest rate move, credit spread changes and redemption requests would, in fact, cause the fund to break the buck." He continues, "The application to floating rate money markets and to hedge funds is clear: by defining an appropriate threshold as an equivalent breaking point, the fund can simultaneously stress the relevant factors for its investment types to that breaking point.... The same redemption risk that affects money funds can impact hedge funds: matching investor redemption requests with liquidation of assets is a universal function of portfolio managers." He concludes, "Cross-fertilisation of ideas is a hallmark of innovation, and learning from others is an efficient way of improving our own practices. While it may seem strange to voluntarily adopt a regulator's requirements for a different part of the financial services industry, I believe that the SEC's money market stress tests present a thoughtful approach to practical risk management so that the manager of a money market fund or hedge fund has better foresight of possibly damaging scenarios and increased time to react. These analyses can help fund managers make better risk decisions."
