This is an Insight written by an external organisation. The following article was written by Deutsche Asset Management and represents their views.
As Europe prepares to implement money market fund reform, it is likely most prime funds will convert to the new LVNAV (low-volatility net asset value) structure.
A crucial question remains: will LVNAVs be considered ‘cash and cash-equivalents’ for accounting purposes, as today’s prime funds generally are? The answer will have potential ramifications for the investment and liquidity policies generally of companies and institutions.
Back to the boards
LVNAVs will share many features with current prime funds1, offering security, liquidity and yield—and with some additional features that investors will welcome, such as greater diversification. In normal circumstances, they would be expected to trade at a constant price (1.00/share).
Regardless of these similarities, investors wanting to continue using money market funds under the new structure may wish to ensure they remain compatible with their investment policies, and seek new approvals from their boards and investment committees, where applicable. And it will be up to accountants to decide how LVNAVs may be treated on balance sheets.
In the US, where money market fund reforms came into force in October 2016, the Securities and Exchange Commission offered guidance to the effect that a floating NAV fund could be considered a cash-equivalent. At the time of writing, there are no indications that European regulators will follow suit, and it is doubtful that the major accountancy firms will publish a broad opinion on the matter. More likely, the accounting treatment of LVNAVs will come down to company- or institution-level determinations, made largely on a case-by-case basis.
Timeline
July 21, 2018 — Reforms effective for new funds
January 21, 2019 — Reforms effective for existing funds
Defining cash
Where does this leave investors? We should stress that we are not accountants. But we have been closely evaluating the new fund format to assess how it will operate in practice. It may therefore be helpful to examine the likely real-world characteristics of LVNAVs, through the lens of the formal definition of cash-equivalence.
According to the International Accounting Standards (IAS), cash-equivalents are “short-term, highly liquid investments that are readily convertible to a known amount of cash, and that are subject to an insignificant risk of change in value.” Below, we consider each of the elements of this definition in light of what we expect from LVNAVs.
LVNAVs: Cash or cash-equivalent?
Like prime funds, LVNAVs will be considered short-term: they are one of three money market fund types categorised as such under the new regulations—the others being constant NAV funds, which invest primarily in public debt; and certain variable NAV funds. The criteria for short-term funds are the existing European regulatory guidelines, which include having a weighted-average maturity of 60 days or less, and a weighted-average life of 120 days or less.
Our expectation is that LVNAVs will be extremely liquid—in fact, so much so that returns will be somewhat constrained relative to today’s prime funds. This is because LVNAVs will be subject to stricter liquidity rules, aimed at ensuring they can always convert sufficient assets into cash to meet investors’ withdrawal requests. These include holding a minimum of 30% of their portfolios in securities that mature within a week, one-third of which must be in daily maturing assets. Current guidelines and contractual rules stipulate a minimum allocation to weekly maturing assets of 20%.
One of the most discussed elements of the reforms has been the rules concerning fees and gates, which are aimed at slowing redemptions in times of market stress—understandably raising questions about how “readily” investors might be able to redeem. Under the changes, the conditions in which LVNAVs and public-debt CNAVs may impose restrictions include weekly liquidity falling below 30% and daily net redemptions exceeding 10%.
It is worth remembering that prime funds can already impose restrictions—though, in our view, the industry-led changes since the financial crisis have further decreased the likelihood of them being used. LVNAVs will be slightly more conservative than today’s funds, which should give investors further comfort. Given this, we think the key risks that influence the likelihood of fees or gates being activated will remain the same: sudden interest rate changes and unforeseen market events.
Under a 1.00/share approach, investors have usually felt confident they could redeem their holdings for an amount that was, for all practical purposes, “known”. Yet in reality, ‘constant’ NAV funds have always had the potential to switch to variable pricing in extreme circumstances—just as LVNAVs will.
Under the new regulations, LVNAVs are in fact deemed a type of CNAV; the difference is that they will be subject to stricter limits on when they can offer constant pricing. To do so, managers must keep the net asset value of an LVNAV within 20 basis points of 1.00; the equivalent collar for a prime fund is 50 basis points.
Despite the tighter collar, our analysis suggests that LVNAVs will comfortably be able to meet the conditions for pricing to remain constant in most scenarios. In stressed conditions, given investors’ strong preference for constant pricing, our expectation is that managers would adopt a conservative approach to ensure they steer well away from the conversion triggers. Nevertheless, investors should be aware of the rules so that they can form their own judgement.
Whether or not a risk is “insignificant” is clearly another matter of judgment. But in reaching a conclusion, it is important to understand how the value of an LVNAV is calculated.
LVNAVs must use mark-to-market accounting to value assets with residual maturities greater than 75 days, and to value any individual asset if its marked-to-market price differs by more than 10 basis points from its amortised cost value. As a point of reference, about half of the assets in a typical prime fund might have maturities greater than 75 days.
Currently, prime funds use amortised cost accounting for all of their assets—that is, valuations start at the acquisition cost and are gradually decreased over time. The new approach will clearly make LVNAVs’ net asset values less predictably linear. But as we noted earlier, we expect the variations to be small, such that LVNAVs should remain comfortably inside the limits required for constant pricing.
Coming to a decision
From a portfolio manager’s perspective, an examination of the IAS definition of cash-equivalence highlights the close similarities between today’s CNAVs and LVNAVs. However, this is not to pre-empt the decision accountants may reach. Regardless of the definition, the accountancy profession could revise its long-held view on the cash-equivalence of money market funds.
Moreover, the definition is not the only yardstick used to determine cash-equivalence. There are typically two other methods: looking through to the underlying investments (which, again, will be slightly more conservative for LVNAVs); and by considering the intended use of the holding—in other words, whether it is being used as cash or for investment purposes.
Looking ahead
Early guidance on this issue would be helpful for money market fund investors—though the precedents set by France and the US, where variable NAV funds have been deemed cash-equivalent, may offer some reassurance. We will keep our clients updated on developments as the implementation dates near.