MMFs with Floating vs. Fixed Share Prices

A discussion on an unrelated thread regarding historical pricing on brokerage statements for GICs eventually expanded to include historical pricing for Money Market Funds. As MMFs are marketable instruments, there are wider implications of this policy than there are for GICs.

Jonathan Witmer of the BoC wrote a working paper in 2012 titled Does the Buck Stop Here? A Comparison of Withdrawals from Money Market Mutual Funds with Floating and Constant Share Prices:

Recent reform proposals call for an elimination of the constant net asset value (NAV) or “buck” in money market mutual funds to reduce the occurrence of runs. Outside the United States, there are several countries that have money market mutual funds with and without constant NAVs. Using daily data on individual fund flows from these countries, this paper evaluates whether the reliance on a constant NAV is associated with a higher frequency of sustained fund outflows. Preliminary evidence suggests that funds with a constant NAV are more likely to experience sustained outflows, even after controlling for country fixed effects and other factors. Moreover, these sustained outflows in constant NAV money market funds were more acute during the period of the run on the Reserve Primary fund, and were subdued after the U.S. Treasury guarantee program for money market funds was put in place. Consistent with the theory that constant NAV funds receive additional implicit support from fund sponsors, fund liquidations are less prevalent in funds with a constant NAV following periods of larger outflows.

This paper is the first to examine the usage of a constant NAV structure across countries. It is well known that money market funds in some countries, such as the United States, employ a constant NAV structure. It is less well known to what extent other countries use a different structure. The main difference between floating NAV and constant NAV money market funds is the use of amortized cost accounting. Floating NAV money market mutual funds measure the value of their positions using fair value or market prices. For constant NAV money market funds, the value is recorded as the initial cost, plus the straight line amortization of the position’s premium or discount at the time of purchase through to the position’s maturity date. This paper shows that many European countries have a mixture of both fund types.

Here’s the interesting bit – how predatory traders are able to fleece naive investors:

This paper also contributes to the broader literature that examines the relation between stale share prices, illiquid fund holdings, and fund flows in equity and bond mutual funds. Arbitrageurs can take advantage of stale prices in illiquid mutual funds at the expense of the remaining shareholders. These apparent arbitrage opportunities induce a change in flows in these mutual funds. The paper by Lyon (1984) finds this arbitrage activity dilutes other shareholders in money market funds by an estimated 10 bps per year. This dilution is even larger in international equity mutual funds, where dilution can be upwards of 1% per year (e.g., Greene and Hodges, 2002; Zitzewitz, 2003).

During the first part of September 2008 when there was a run on the Reserve Primary Fund, constant NAV money market funds experienced more outflows than did floating NAV money market funds. Further, after the U.S. Treasury implemented its guarantee program for money market funds, constant NAV U.S.-domiciled U.S. dollar funds performed much better and sustained a decrease in prolonged outflows during the guarantee period, relative to non-U.S. domiciled U.S. dollar funds.

After the crisis, the SEC amended rule 2a-7 to improve the resiliency of money market mutual funds. These amendments included tighter restrictions on the credit quality, maturity, and liquidity of portfolio holdings for money market funds. The maximum dollar-weighted average maturity was reduced to 60 days, and a maximum dollar-weighted average life to maturity was introduced and set at 120 days. As for the liquidity requirements, a minimum of ten percent of a fund’s portfolios must be invested in “Daily Liquid Assets” and a minimum of thirty percent must be invested in “Weekly Liquid Assets”. The amended rule 2a-7 also requires monthly website disclosure of portfolio holdings, including information

The author concludes, in part:

This paper has several important policy implications. There is an active push to reform money market mutual funds in the wake of the financial crisis and more specifically following the run on the Reserve Primary Fund and subsequent government support of money market funds in the United States. One of the primary proposals is to move away from the CNAV money market fund structure and towards the VNAV structure. Some observers have contended that such a move does little to reduce the occurrence of runs in money market mutual funds, based on anecdotal evidence of run behaviour in ultrashort bond funds in the United States and enhanced money market funds in Europe, both of which maintain a VNAV structure (Investment Company Institute, 2011; HSBC, 2011). These funds, however, are not subject to the same liquidity, credit, and maturity restrictions as money market funds. This paper compares a large number of money market mutual funds across several countries and finds that, on the contrary, the VNAV structure is less susceptible to run-like behaviour relative to CNAV money market funds.

However, the VNAV structure does not fully eliminate this run-like behaviour. This is consistent with the model of Chen, Goldstein, and Jiang (2011), which shows that mutual funds holding illiquid assets experience more outflows following a period of poor performance, relative to funds holding liquid assets (their empirical examination focuses on equity mutual funds). That is, in their model investors may redeem on the self-fulfilling belief that others will be redeeming, imposing the costs of liquidating the fund’s illiquid assets on remaining shareholders. While money market funds generally hold liquid, shortterm assets, these assets may become illiquid during periods of stress or, put another way, during periods when there is a belief that a fire sale of some money market fund holdings may occur. Even during periods of stress, however, CNAV money market funds are more prone to run-like behaviours, relative to VNAV money market funds.

Given my own views on the subject, expressed in A Collateral Proposal and The Future of Money Market Regulation, I was most interested in his final paragraph:

Not only does the CNAV structure have a higher occurrence of sustained outflows, but also there is some evidence to suggest that it is associated with an implicit guarantee provided by fund sponsors. This implicit guarantee has both advantages and disadvantages. The presence of an implicit guarantee can reduce moral hazard and reduce risk-taking in money market mutual funds, since the fund sponsor would be concerned that the poor performance of the fund may have negative spillovers on the sponsor’s other businesses (Kazpercyk and Schnabl, 2012). The amount of risk-taking depends upon both the sponsor’s financial strength as well as the reputational concerns about the effect of “breaking the buck” on the rest of the sponsor’s fund and non-fund businesses. On the other hand, an implicit guarantee is a potential channel for contagion between the banking sector and money market mutual funds. Losses in a money market mutual fund may be passed onto the fund sponsors should they provide support to the fund. As well, a weakening of a fund sponsor could be passed onto the money market fund sector through a reduction in the value of the implicit guarantee.

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