Portfolio Management of Money Market Funds Chapter 7 Portfolio Management of Money Market Funds

Conditions for Stable $1 NAV Money market funds may maintain a stable $1 NAV if they meet the tests set out in SEC Rule 2a-7. If they meet these tests, they may use amortized cost accounting to compute their NAV. Amortized cost accounting allows funds to use the price paid for a security (rather than current market value) in the NAV calculation. A stable NAV is reasonable because money market funds hold securities that are: Of very high quality. That have only a short time to maturity. As a result, the odds are high that these securities will be redeemed at face value.

Rule 2a-7 Maturity Credit quality Diversification Liquidity Rule 2a-7 ensures that money market funds are invested very conservatively. Maturity of single security limited to 397 days. Weighted average maturity limited to 60 days. Maturity 97% in one of top two categories. Credit quality Maximum of 5% of assets in securities of single issuer if rated in top two categories. Maximum of 0.5% of assets in other issuers. Diversification At least 10%: daily availability. At least 30%: weekly availabilit.y Maximum 5% illiquid. Liquidity

Shadow Pricing The board of directors must compare the shadow price to the $1 NAV. The shadow price is the NAV computed using market prices. If the shadow price is higher than $1.004 (= above $1 by more than a half a penny)*: The board will distribute income to reduce the NAV to $1. *This is an unlikely scenario because money market funds rarely realize capital gains.

Breaking the Buck If the shadow price is lower than $0.995: The fund has broken the buck. The board will stop using amortized cost accounting and switch to a market value NAV. The board may suspend redemptions so that the fund can be liquidated in a orderly manner. Money market funds have broken the buck only twice. Community Banker’s U.S. Government Money Market Fund (1994) Reserve Primary Fund (2008) Fund management companies may provide financial support to keep funds from breaking the buck.

Directors’ Duties under 2a-7 Monitor shadow pricing and take action if it deviates from $1 by more than half a penny. Monitor credit quality and confirm that manager’s research practices are rigorous. Review policies and procedures used to assure compliance with Rule 2a-7. Oversee stress tests that gauge the fund’s ability to maintain a $1 NAV under certain scenarios.

Holdings in Taxable Money Market Funds (1) Issued by the U.S. government. Funds holding only Treasuries are popular in times of crisis. Treasury securities Issued by federal government agencies or by government-sponsored enterprises, which include Fannie Mae and Freddie Mac. Agency securities Issued by corporations, including banks. Commercial paper

Institutional Money Market Fund Assets Source: Investment Company Institute, 2010 Investment Company Fact Book

Holdings in Taxable Money Market Funds (2) Deposits in banks. Certificates of deposit (CDs) Loans to broker-dealers backed by securities. Very short-term; often overnight. Repurchase agreements

Holdings in Tax-Exempt Money Market Funds Issued by state and local governments. BAN = Bond Anticipation Note TAN = Tax Anticipation Note RAN = Revenue Anticipation Note Municipal notes Often backed by a letter of credit from a highly-rated bank or insurance company. Commercial paper A long-term tax-exempt bond combined with a short-term put option (from a financial institution) that provides liquidity. Variable rate demand notes

Managing a Money Market Fund Money market fund portfolio managers must balance two goals: Maintaining a stable $1 NAV and assuring liquidity to shareholders. Providing a competitive yield. They must monitor: Average maturity of portfolio. Allocation among maturities. Liquidity. Allocation among types of securities.

Money Market Funds vs. Bank Deposits Money market funds are often used interchangeably with savings accounts, but there are clear distinctions. Provided by both. Immediate access to funds Provided by both, through different mechanisms. Payment of competitive interest rates Carried by bank deposits only. Money market funds provide security through diversification.. Fed. Deposit Insurance Corp. insurance Banks have local presence through branches. Both now provide telephone and online access. Local convenience Both provide other services such as check-writing. Banking services