Over the next weeks and months, changes will be occurring that will affect cash investors significantly. Although we are still experiencing a zero – rate environment that began three years ago, it has not been a zero – risk environment for the cash investor. So far in 2012 the “playing-field” has become more uncertain as regulatory changes, banking changes, and other environmental changes continue to evolve. Overall, Commonfund’s point of view on cash investment objectives has not changed. A cash investor’s primary concern should be safety and liquidity with a distant third objective being return. Cash investing liquidity is about “return of capital” not “return on capital”.
As we stated in September 2011, exposure to European financial institutions in “prime” money-market funds continues to be a concern to investors due to sovereign debt problems in the region and the risk of contagion with the European banking system. We do not have specific concerns with any of the three providers on the Treasury Access platform: State Street Global Advisers, J.P. Morgan Asset Management and BlackRock, and we also note that they have been decreasing exposures to European financial institutions over the past months. Commonfund’s point of view in September was that the minimal incremental yield generated by allocations to the “prime” money market funds on the Treasury Access platform did not justify taking the additional risk. Although the prime fund yields have increased somewhat over the past months, investors should still be cautious before committing to the additional risks in prime funds.
Outside of the events in Europe, the most eminent change in liquidity investors are facing is not an economic change, but a regulatory change. Since the financial crisis, regulatory agencies have worked to take systemic risks out of the financial system, with specific concerns for bank accounts and money market mutual funds (“money funds”). Banks have benefited from a temporary unlimited FDIC insurance for non interest bearing accounts. This unlimited insurance has significantly increased bank account balances in 2012. Commercial checking accounts are over $700 billion in balances, up 38 percent since last year and commercial savings deposits are over $5 trillion in balances, up 11 percent from last year. However, the current FDIC insurance provision is scheduled to expire at the end of December. We anticipate that when unlimited FDIC insurance reverts back to more normalized levels ($250,000 per account holder), significant institutional cash outflows should be expected from bank accounts, and investors will be searching for alternatives to hold liquidity alternatives.
Money funds have undergone significant reforms since the financial crisis. In fact, the SEC Rule 2a-7 amendments of 2010 were the most substantive since its inception in 1974. The sweeping SEC reforms added higher liquidity requirements, stricter limitations on holdings, and added more transparency to this area of the capital markets. The changes successfully made money funds more resilient to financial downturns; however, they did not fully eliminate systemic risks inherent in the industry. Further reforms are now being proposed, and may be implemented in some form over the next months. The SEC will unveil in the coming weeks a plan to further stabilize the money fund industry. On the table are three proposals, the first two being to (1) require money fund providers to set aside capital reserves and (2) to restrict investor redemptions so that only 95 percent of an investor’s holdings are accessible immediately. The third and most controversial proposal is to eliminate the stable $1 NAV pricing of money funds. The SEC’s plans have evoked strong pushback from individual providers and the Investment Company Institute (ICI – the National Association of Investment Companies) on one, or all, of the proposals. Commonfund anticipates that the SEC will seek comment on its proposals over the next months which will be followed by an ensuing debate between regulators and industry providers which may take months to formulate the next round of reforms. At this point it is early to handicap possible outcomes of which reforms will be adopted.
The current zero rate environment has added severity to the issues in the money fund industry. Current regulations of two years ago increased fund expenses (related to reporting and transparency requirements) and the subsequent addition of new reforms could add another level of expense. In this zero rate environment, yields on these very short investment programs are in some cases not covering expenses, especially in Treasury only and Government Security programs. If the Fed funds rate were increased by 50 basis points, the yields of these funds would more easily cover present and future expenses. However, we do not envision the Fed tightening for the sole purpose of assisting this area of the capital markets. Money fund providers will need to adapt to the present difficult environment and weather an extended low rate environment without any certainty of when markets return to a more normalized rate environment. Commonfund believes this will lead to further industry consolidation where well capitalized, highly committed providers will survive. Commonfund will continue to select and oversee providers that are best positioned to manage through current and upcoming challenges.
Overall liquidity is more expensive to hold in the current environment as revenues (yields) are not fully offsetting expenses. Liquidity investors need to focus on safety and liquidity; however there may be opportunity risk for the cash investor that holds excess liquidity. Investors that segregate liquidity needs from other operating cash are able to take more risk and therefore benefit from credit or duration strategies. Commonfund has encouraged institutions to “tier” their operating cash in order to determine liquidity needs and funds not needed for working capital. Current liquidity levels should be determined by cash flows, working capital projections, self-liquidity requirements by rating agencies, capital spending support, and so forth.
In conclusion, investing in the current zero rate environments has become more risky and more challenging. Diversification and flexibility will be key components to an operating policy and in managing a cash portfolio. Regulations will evolve and investment providers will adapt over the next months. Investors will need to monitor these changes internally, or outsource this responsibility to a capable provider, in order to react quickly and effectively.
Statements concerning Commonfund Group's views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group's policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information.