Money market funds have become firmly established as a mainstream cash management tool in the USA. The stage is set for the UK and European markets to follow.
Beyond Europe, too, the prospects are hailed as bright. "We believe there are exciting opportunities everywhere," concludes Paul Thomson, head of offshore funds at Goldman Sachs in London. "Governments and corporates around the world are examining different ways of managing their cash; the use of triple-A-rated funds is gaining widespread acceptance as a means of achieving diversification quickly and cost-effectively without compromising on security."
"It's the next logical step in the development of investment services," says Randi Weaver, UK sales manager at Mellon Global Investment in London. "You have ease of administration and same day liquidity. Yields are higher on funds than on bank deposits, and you gain that higher yield without sacrificing credit quality; it's a win-win situation."
The potential is obvious, and huge. Industry calculations indicate there is some $1.7 trillion of assets in US money market funds. In the UK and Europe, the equivalent figure is estimated at around a mere $40bn (up from around $30bn a year ago).
"In response to shifts in the investment panorama and investor practices over recent years, an increasing number of leading US and European institutions have identified the need to augment specialised cash management services as a natural extension of expertise and product line," observes Ashley Meek, secretary of the embryonic International Money Market Funds Association. "Through direct participation in, or more recent assimilation of, the US experience, both sets of institutions are striding forward with the offshore European replication of the US concept as a logical, ready made and well tested solution."
A survey of 200 of the largest European corporates and banks carried out by JP Morgan Investment Management towards the end of last year highlighted a strong preference for money market funds as opposed to any other form of short-term investment. A total of 71% of corporates showed a strong interest in investing in money market funds, although 74% convinue to invest primarily in bank deposits.
US-style money market funds arrived in Europe in the aftermath of the Barings collapse in 1995, targeted at corporates, pension funds, insurance companies and banks themselves.
A combination of factors is behind the growth of money market funds on this side of the Atlantic. One, the extended low interest rate and low inflation environment has focussed attention upon the impact of squeezing extra yield from each and every investment; money market funds not only make the management of short-term cash easier, but also offer rates comparable to or in excess of traditional overnight deposits. Two, there is a new emphasis within many corporate treasuries on executing higher value added work than seeking out the most competitive rates. "Why spend all day analysing credit and assessing assets available in the market when you can outsource?", asks one money market fund manager. Three, the increased popularity of 'custody cash sweeps', as custodian banks move client funds off their balance sheets in a way that profits both parties. Four, triple-A-rated funds are safer parking spots for short-term cash than most banks are. Five, money market funds are designed for same-day settlement within a specified cut-off time. Six, banks often have too much cash and have no interest in leaving large quantities sloshing around the balance sheet.
The use of money market funds is likely to increase dramatically in the coming years as the high interest levels expressed by putative investors are converted into actual investment, according to Peter Knight, head of institutional liquidity JP Morgan Investment Management. "Increasing cross-border competition is forcing banks to reconsider their core business and move from the low margin, expensive, short-term bank deposit business to cash funds. In addition, cash management is no longer complicated by currency exposure [in the euro zone], and same-day settlement systems have made cross-border cash management possible for the first time."
High yielding, secure money market funds that offer instant liquidity and a high degree of customer service make sense to corporates, says Knight. Banks too are increasingly seeing the benefit of money market funds as a means of generating commission income without expanding their balance sheets with unwanted deposits. Funnelling cash into their own or third party money market funds enables banks to maintain client contact while increasing their return on capital.
In simple terms, a money market fund is a diversified pool of high grade, short dated money market assets. The fund is actively managed within strict guidelines to ensure that the pound paid in today is the pound paid out tomorrow, with a day's accrued competitive interest, net of management fees. In the US, money market funds are defined precisely by law, laying down the maximum duration of a single investment, for instance. Although these laws do not exist in Europe, the predominance of US-regulated banks amongst the leading players dictates that most funds operate under US terms.
"Variables in a cash fund are the duration of the instruments invested in and credit quality," says Robin Creswell, responsible for investor relations at the London arm of Los Angeles-based Payden & Rygel, an independent investment firm specialising in the active management of short-term assets. "The fund manager's job is to apply his skills to buying the right paper and managing duration risk. Until recently, the focus has been on improving the yield; that focus has shifted to credit quality." Most funds are credit quality-rated by the major rating agencies, some carry an additional volatility rating, reflecting their exposure to interest rate fluctuations.
A critical component of a fund's susceptibility to rising interest rates is its weighted average portfolio maturity, which is specifically restricted by rating category, says Ashley Meek. At the triple-A level, funds are required to stay within a 60-day limit, an optimal level derived from portfolio stress testing analysis. Other variables evaluated include instrument liquidity, risk aversion strategies, operating procedures and internal controls. "Due to the precision necessary in running a money fund successfully, every aspect of the fund's operation must be able to withstand close scrutiny and emerge with its integrity intact."
"We will see an increasing number of providers, and inevitably a period of consolidation," says Peter Knight, summarising the near to medium-term outlook for the product and its providers. "We will see an increasing acceptance of money market funds in Europe, as awareness of the product grows at corporate clients and pension funds. The market took off on an exponential curve in the US; the European market is entering that phase."
"We remain very much in missionary mode," concludes Adrian Mearns, director and head of sales, institutional cash management, at Fidelity in London. "There is still a great deal of work to be done, but we are seeing a gradual erosion of diehard habits. Once organisations start using money market funds, they don't look back."