Sometimes risk reduction and capital preservation are of higher importance than pursuit of return.  When major questions about underlying holdings of a fund arise and potential risks are significant, we think standing aside and waiting for the issues to resolve is the prudent thing to do.  That’s where we stand on money market funds today.

Consider, for example, these excerpts from the Financial Times (Aug. 20) in an article titled ” Money market funds abused, claims founder”

“Bruce Bent, the inventor of the money market fund, has criticised the ‘flagrant abuse’ of the concept – which he introduced in 1970…  [He has] a sense that many money market funds have exposure to sectors or securities they should not be in .

… [The] desire of some cash managers to post the best possible yield has left many overextending their reach and investing in areas such as subprime paper. … [an extreme current example] Sentinel Management Group, a US money management firm, pointed to problems in the money markets when it filed for bankruptcy last week after having frozen its funds.

This month, Axa Investment Managers in France said it would shore up two of its money market funds that had invested heavily in subprime loans.”

Also consider today’s page one Wall Street Journal article titled “Fed Fails So Far In Bid to Reassure  Anxious Investors” which said.

“… The latest wave of risk aversion in the credit markets is being led by managers of money-market funds, which are designed to behave like bank accounts and whose primary goal is to avoid losing money for investors. … Michael Cheah, a fixed-income portfolio manager at AIG SunAmerica Asset Management, said ‘This is about dealing with what we don’t know. There is little margin for error in money-market funds.’ “

It is unlikely that the vast majority of money market funds hold “bad paper”, and those few who may will probably “eat” their losses to avoid “breaking a buck” price level for their funds.  However, today with so much confusion and so many responsible experts saying that pricing and valuation are difficult at best, we chose to stand aside for a while.

Therefore, several days ago we converted our personal money market assets, and recommended that our clients convert their accounts, to money market funds holding only U.S. Treasury securities.  We gave up approximately 50 basis points in doing so – a price we gladly pay for the next few months to have cold comfort that our $1.00/share money market assets will be worth $1.00 in the future.

Consider that if we wait 3 months for the situation to settle, we lose only 17 basis points of return on an annual basis.  We think that is a reasonable price to pay for cold comfort.

The money market component of a portfolio is supposed to be the lowest risk component, exposed to inflation risk, but not to market risk.  We recommend this temporary redeployment to assure that it remains the lowest risk component without market risk.

If return were the goal, the assets would not have been in money markets in the first place.  Money markets are the place to park money that has near term uses and for assets that should not be exposed to market risk.  Either way nominal capital preservation is the #1 goal.

News of the risk is not new, but the advice still makes prudent sense for a temporary change in portfolio composition for risk reduction.

Richard Shaw
QVM Group LLC 

This entry was posted on Tuesday, August 21st, 2007 at 12:32 am and is filed under Risk Management. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.