Like grasshoppers trying to cross a pond full of frogs, investors are feeling pretty jumpy this summer, with dim hopes of making it through alive. There are plenty of reasons for the tension:
• Three years since the last meaningful correction in 2011 have increased the devastation potential of the next one,
• The spectre of rising interest rates is closer than it has been before, with rising inflation and falling unemployment increasing the chance of rates rising sooner than later,
• The escalation of conflict in Ukraine is prompting analysts to lower European growth estimates, which are in turn expected to put a drag on the global recovery,
• The escalation of violence in Iraq threatens oil flows, driving up the cost of energy and hurting all economies,
• The fear of an Ebola pandemic could disrupt travel and further slow business activity,
• And of course, the summertime lull, with its low volume and high volatility which could easily exacerbate even the smallest pullback into a more exaggerated correction.
On Friday we saw how amidst such tension all it takes to plunge the markets is one headline – in this case a strike by Ukraine on a Russian military column, which sent the S&P 500 reeling some 1.2% in the span of little more than an hour.
The markets also received news early Friday morning that renowned investment guru George Soros and his team of money managers have increased their put option positions on the expectation of a solid hit to markets over the near term.
What are investors to do? Sell everything and sit this one out on a pile of cash-based positions like T-bills and money market funds? While fleeing to the safety of 100% cash is clearly going to the extreme, advisors do recommend holding a modest amount in cash as an emergency store of liquidity in the face of a sharp correction, as well as a reserve with which to take advantage of cheaper prices and snap up some bargains.
Knowing that it’s always wise to hold part of our portfolio in cash (at varying amounts depending on the amount of risk in the market at any given time) the question investors now need answered is: where do we keep this cash? We have two important considerations to make:
Consideration 1: Not all money market vehicles are as low risk as they appear.
Consideration 2: You may be taking on more safety than you need, sacrificing more profit than you should.
Today’s article will look at the first consideration, while tomorrow’s will consider the second.
Distinguishing Between MM Accounts and Funds
For our first consideration, we need to note a very subtle but important difference between money market funds and money market accounts.
Simply put, money market accounts are those offered by your bank, similar to a savings account, but with a slightly higher interest income, often accompanied by minimum requirements or redemption restrictions.
Money market funds, on the other hand, are similar to investment mutual funds whose value is determined by the underlying investments held, and which afford the managing firm a little more flexibility on how they are managed.
While both MM accounts and funds typically invest in the same vehicles – such as Treasury bills, municipal bonds, certificates of deposit (CDs) and corporate commercial paper characterized by low-risk and high-liquidity – only MM accounts are protected by the Federal Deposit Insurance Corporation (up to $250,000 per client), while MM mutual funds are not.
The main reason why MM funds are not insured is that, as tradable securities, they fall under the rules of the Securities and Exchange Commission (SEC) and/or the Commodities Futures Trading Commission (CFTC). Since MM mutual funds are classified as securities, the firms managing them are permitted to move client funds around under certain circumstances, as the New York Times explained:
“There are legitimate reasons to move assets from segregated accounts, the most common being that they are overfunded… If there’s an excess (many firms deliberately overfund the segregated accounts to make sure there is never an inadvertent shortfall), they can transfer the excess funds…
“The law also allows commodities firms… to use segregated customer funds as a source of low-cost financing for their own operations, but they are required to replace any customer assets taken from segregated accounts with supposedly ultra-safe collateral of the same value, typically United States Treasuries, municipal obligations, and obligations whose payments of principal and interest are guaranteed by the government.”
In some cases, then, fund companies can dip into their clients’ accounts for certain purposes, while always staying within proper control measures and procedures. The problem, however, is that the commodities and securities industry is mostly self-regulating.
If Temptation Strikes
While certain organizations like the Financial Industry Regulatory Authority (FINRA), the Chicago Board Options Exchange (CBOE), and other exchanges do “conduct periodic examinations and audits… member firms are required to have internal controls and compliance mechanisms to make sure that customer assets remain safely segregated at all times,” NYT elaborates.
Unfortunately, in times of crisis – such as 2008, for instance – the temptation to dip into client accounts is nearly impossible to resist, especially if the firm has made too many bad investments elsewhere and is in danger of collapsing. This is how clients who were invested in supposedly safe money market mutual funds with now defunct MF Global lost their money. As NYT puts it, “An estimated $1.2 billion in customer assets had vanished at MF Global.”
Another well-known MM mutual fund that fell victim to the 2008 financial crisis was the Reserve Primary Fund, “which once held more than $60 billion in assets,” reported the Wall Street Journal, but whose “net asset value on Sept. 16, 2008 dipped below the $1 a share that money-market funds strive to maintain” – an event known as “breaking the buck”.
Only around 92% of Reserve Primary Fund’s assets prior to the meltdown were returned to clients, meaning that investors lost 8% in one short summer, amounting to some 8 years’ worth of interest at 1% per annum (assuming the fund paid that much to begin with).
Two Primary Causes that “Break the Buck”
What caused the Reserve Primary fund to “break the buck” and dip below par value, something which MM funds are not supposed to do? “The fund’s manager was attracted by the high yields he could earn on the Lehman [Brothers] debt,” informed CBS Money Watch. Lehman ultimately dissolved in one of the largest bankruptcies in U.S. history.
Money market funds are supposed to preserve your investment. But certain flexibilities afforded to their managers can result in asset values dropping below that $1 per share par value.
While such significant losses of 8% in an MM fund are very rare, “breaking the buck” is not. Sometimes, all it takes to plunge an MM fund’s asset value below the $1 mark is a mass-exodus, where large numbers of clients redeem large numbers of units all at once – which can happen during a correction when investors need to raise cash in a hurry.
Ironically, the time when you depend on money market funds the most – during a major correction – is also the time when they can fail you the most, either through bad management or large scale redemptions en masse.
Rethinking Our Cash Positions
With such minimal interest returns of generally less than 1% per year, investors could lose an entire year’s worth of interest in just one day, not to mention a chunk of principal over the course of a prolonged correction.
This now presents us with some questions we might not have considered before:
• If we knew all the things fund managers are doing with these supposedly low risk money market funds, might we need to put them in a slightly higher risk category than we currently hold them at?
• If we do acknowledge they carry a higher level of risk than once believed, doesn’t that put money market funds alongside other instruments that offer higher rates of return for this same newly-acknowledged higher level of risk?
• And seeing as money market funds offer such dismal returns of less than 1% per year while not being riskless, might we be short-changing ourselves by investing in them over the long term? After all, corrections have historically averaged a spacing of about 20 months between them, with severe corrections occurring perhaps once every five years. That’s a long time to go with such dismal returns.
In reality there are plenty of investment vehicles that offer solid protection while generating much higher returns than MM funds. In tomorrow’s article I will present what I believe to be some of the better ones.
Although the risk is slightly greater than a money market fund, these instruments still qualify as safe places in which to store our cash reserves while we wait for a correction – but offering as much as 5 times more income than even the best paying MM funds out there.