Can Money Market Funds Survive Variable Net Asset Values?

Abstract

We propose a variable Net Asset Value (NAV) approach based on a dual-NAV structure to preserve the transactional utility of money market funds. This approach would require funds to publish daily intrinsic NAVs up to the 4th decimal place, and would allow shares to be traded at rounded NAVs (RNAVs) up to the 2nd decimal place. Results from our studies show that, when prudently managed, RNAVs at $1.00 are achievable even under severe market conditions. Such studies cover shadow NAVs of large prime funds, normalized NAVs of an ETF and an ultra-short bond fund, and prime fund NAVs in FundIQ® stress tests.
We believe that recent regulations have sufficiently addressed portfolio risk within money market funds. However, the dual-NAV approach may provide further shareholder risk mitigation. We think that this approach is less disruptive than the proposals being considered, and since a variation of the approach already exists, its implementation likely will encounter the least resistance.

Introduction

With each passing day, constituents of the money market fund industry wait with growing anxiety for the Securities and Exchange Commission (SEC) to announce its proposals for additional industry reform. Based on recent speeches from SEC officials and reports by the media, variable net asset values (VNAVs), capital buffers and holdbacks on share redemptions seem to be the three likely outcomes.
Not surprisingly, the fund industry and many institutional shareholders dislike all three solutions, suggesting that implementing any of them could mark the end of the popular investment vehicle as we know it and bring unnecessary stress to financial markets at large. On the other hand, government officials, notably SEC Chairman Mary Schapiro, feel strongly that the fund industry is operating without a safety net and that additional regulation is needed to address the funds’ structural vulnerability.

The Dual-NAV Approach

Are the views from the two sides irreconcilable? Can money market funds operate under the existing SEC Rule 2a-7 framework and sufficiently avoid the dramatic capital flight that occurred in the wake of the Lehman Brothers bankruptcy in 2008? After studying the NAV history of a number of pooled vehicles, we suggest that a modified version of the VNAV approach may bridge the gap between the private sector and the regulators.
The dual-NAV approach mimics the daily premium/discount presentation of closed-end funds and exchange-traded funds. It modifies the conventional VNAV approach by abolishing the amortized cost method, requiring funds to publish intrinsic NAVs (INAVs) daily up to the 4th decimal place ($0.0000), but allowing shares to be traded at rounded NAVs (RNAVs) up to the 2nd ($0.00) decimal place. Results from our studies show that RNAVs at $1.00 are achievable even under severe market conditions when managed prudently. The INAV disclosure eliminates information asymmetry in underlying asset values, a primary cause for shareholder runs.
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