KIM: Even money market funds can be risky for investors

Money market funds are are a huge business. As of September 2011, U.S. money market funds had total assets of $2.6 trillion: $300 billion in tax-exempt funds, $900 billion in government funds, and $1.4 trillion in non-government “prime” funds.

All seek to offer a stable net asset value of $1 per share. In other words, investors purchase and redeem money market fund shares at the same price of $1 per share. But funds must adhere to strict Securities and Exchange Commission regulations governing the credit quality, liquidity, diversification and maturity of their portfolios.

Before the financial crisis, money market funds occupied the sleepiest corner of the investment universe. These were places you parked money until you had something better to do with it. You typically received a little more interest than at a bank and never had to think about it.

That ended abruptly in September 2008, when Lehman Brothers went bankrupt. That left the $62.5 billion Reserve Primary Fund holding $785 million of loans to Lehman that were suddenly of dubious value. Reserve Primary became just the second and largest money market fund to “break the buck” when its net asset value dropped below $1 a share.

That touched off a run on Reserve Primary, which then spread like wildfire to other prime money market funds. During the single week of Sept. 15, 2008, investors withdrew $310 billion from such funds, representing a loss of about 15 percent of net assets. Some prime money market funds saw assets under management drop more than one-third in less than a week.

What was true with the Bailey Brothers Building and Loan Association in “It’s a Wonderful Life” rang true. No bank or money market fund has enough liquidity to pay depositors or investors if everybody wants out at the same time.

The run was halted only when the government temporarily guaranteed money market fund account balances with the Treasury Money Market Fund Guaranty Program, just one of many in the alphabet soup of improvised rescue programs.

Following the crisis, the SEC enacted reforms designed to strengthen the resiliency of money market funds to credit losses and reduce the risks of runs. Credit quality standards were tightened, maturities were shortened, liquidity requirements were imposed for the first time, and the funds were required to post monthly portfolio holdings on their websites.

The Federal Reserve reduced its target for short-term interest rates to essentially 0 percent during the crisis and has indicated its intention to keep them near there for the foreseeable future. This presents fund managers and investors with a challenge.

For the manager, the recent SEC rule changes have shrunk the universe of allowed investments. The Eurozone debt crisis has compelled managers of prime funds to dramatically reduce exposure to European banks. Finally, in order to provide even a minuscule positive return, managers have been forced to rebate fees.

Unlike bank deposits or CDs, investments in money market funds are not guaranteed. Fitch Ratings reported that on Sept. 30, European banks still represented 37.7 percent of total assets in its sample of 10 large prime funds.

You want to own securities with favorable risk/reward characteristics. While prime money market funds are probably less risky following the recent rule changes, there still is definitely some risk. Know what you own and decide if a reward that rounds to 0 percent justifies assuming the risk, no matter how small.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.