The next few months will tell whether money-market funds continue to play a central role in our finances.
This article originally appeared in the April/May 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
What do money market funds and the Harry Potter novels have in common? Both are well-executed fictions that have become beloved cultural institutions. But while the Potter stories hold a secure spot in our imaginations, the next few months will tell whether money-market funds continue to play a central role in our finances.
That money market funds are less obvious fictions doesn’t make them any less acts of make-believe than popular novels. Money funds are investment vehicles that masquerade as rock-solid banking services. In a sense, they are the supreme realization of the mutual fund industry’s efforts to productize investing. Money funds are packaged so as to minimize the perception of risk and market volatility—two things that are the essence of investing, but also things the public doesn’t like. By creating the impression of perfect stability, the fund industry persuaded the public to take risks it otherwise might not have taken. The public so loved this perception of security and higher returns that it moved massive amounts of assets out of banks and into fund industry coffers.
While money funds are perceived as having absolute qualities, the treasured $1 per share net asset value, which is pivotal to these funds’ ease of use and popularity, is ultimately an illusion. Money market funds are subject to market forces and even to defaults in their underlying securities. Despite increasingly strict rules governing the quality and duration of investments these funds can hold, there have been dozens of cases where money market funds would have broken the buck had not their management companies ponied up millions of dollars to make them whole. The promise of near-infinite liquidity is also a fiction, as seen in the run on the Reserve Fund after its foolhardy bet on Lehman paper. The U.S. government had to step in to provide guarantees to prevent a wider panic. There’s a big difference between almost always getting your money and always getting it.
But even if money funds are based on an illusion, it must be admitted that they are a fiction that the fund industry has told spectacularly well. With extraordinarily rare exceptions, when there have been defaults within money market funds, fund management companies have made the funds whole and maintained the impression of a solid price. The reward to investors has been enormous, especially when contrasted to the losses suffered by investors who held ultrashort-term bond funds where fund companies walked away from their bad decisions. Moreover, money funds are a fiction that has served the public incredibly well. These funds are a wonderful convenience that benefits millions of investors, few of whom would like to see the script altered in any way. Simply put, investors prefer the illusion to the reality.
While the fans of money market funds vastly outweigh the foes, the forces lining up against money funds, like the dark forces in Harry Potter, are indeed powerful. Moreover, they come from both the political left and the right, a rarity in today’s divisive political climate. The left argues that the government must protect investors and taxpayers against their worst instincts and a possible future run on the bank. The right thinks it’s time for us to all grow up and stop believing in fairy tales.
Money funds are investments that carry risk; fund pricing and withdrawal policies, they argue, should recognize this reality.
It would seem that the fund industry, which is strongly opposed to many of the suggested reforms, is outflanked at the moment. The next few months will tell whether the forces against money funds are invincible or if champions of these funds can rally and win a come-from-behind victory.
One thing is for certain: If changes are afoot, they are not going to be popular with most investors. Investors do not want floating NAVs or limits put on their ability to gain access to their cash. Indeed, most investors would argue that if Washington wants to expose financial fictions, then government pension plans would be a far better place to start than would money market funds. (Wouldn’t that be a novel idea?)
As investors, we like to pretend, we want to believe, we treasure the magic of money market funds. We’ll see if our representatives in Washington are willing to shatter our illusions and what the ramifications will be for those who do. I certainly wouldn’t want to be the one to tell a rabid Harry Potter fan that he couldn’t read the next chapter.