For decades, investors in money market mutual funds have assumed that their shares will always be priced at $1. For institutional and municipal money market fund shareholders, that may no longer be the case.
In this article, we’ll examine why the U.S. Securities and Exchange Commission (SEC) established the new “floating NAV” rule and how it impacts investors.
What Is a Floating NAV?
The floating net asset value (NAV) is just as it sounds. While money market funds have always aimed to maintain a stable $1 per share price, the money market reforms that were implemented in 2016 established that institutional money market funds and municipal funds need to allow their daily share prices to fluctuate, or float. Investments in these funds may now experience gains and losses outside of the regular dividend income they receive.
The new policy was instituted primarily due to the events surrounding the collapse of the Reserve Primary Money Market Fund during the financial crisis. In September 2008, the Reserve fund “broke the buck,” thanks to investments in Lehman Brothers commercial paper that became worthless when the company declared bankruptcy. Investors, fearing that further losses might be ahead, pulled their money out of the fund at an incredible rate. Within 24 hours, the fund’s total assets dropped by two-thirds. Due to the number of redemption requests and being unable to meet them, the fund froze redemptions for up to seven days and eventually liquidated the fund altogether.
Regulators, worried that money market fund activity could contribute to financial instability, passed a set of reforms that would make fund providers float the NAV in order to more accurately reflect the value of the portfolio, allow providers to temporarily prohibit investors from withdrawing their balances and impose transaction fees on redemptions.
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Types of Funds Affected by Floating NAV Policy
The new floating NAV rule is aimed at large institutional investors, although the rules surrounding what exactly qualifies as an institutional fund versus a retail fund can be a bit blurry. According to the SEC, institutional funds are loosely defined as those having large minimum initial investment requirements, often $1 million or more. Businesses, endowments, pension plans and other similar accounts generally fall into the institutional definition, although certain accounts held by entities such as small businesses, collective investment trusts and the cash components of stock purchase plans occupy a grayer area.
Retail and U.S. government money market funds will be allowed to maintain the stable $1 per share policy. Accounts held in these funds will be substantially unaffected by the floating NAV rule.
The floating NAV rule carries with it a number of administrative changes outside of just fund pricing. Floating NAV requires a change in the valuation process of the underlying securities. Funds using the floating NAV can no longer use the amortized cost method for valuation. These funds will now need to mark-to-market the portfolio rounding to the fourth decimal place. Trade settlement times will also increase from a few hours to more than a day.
The other major change has to do with trading restrictions and fees. Funds will have the ability to charge redemption fees of up to 2% and freeze redemptions for up to 10 business days in order to prevent rapid selling.
Potential Problems With Floating NAV
The floating NAV rule comes with its share of concerns.
Many big financial companies use money market funds as a cash management tool. If the NAV fluctuates, it becomes less of a cash-like instrument and could push companies to look elsewhere to fill this need.
Floating NAVs could also cause tax headaches since investors would need to potentially account for capital gains and losses.
Money market fund providers would need to improve legal disclosures, leading to heavier regulatory burdens.
In situations where fund companies would need to implement fair value pricing, high volatility could make the process difficult. In these times, volatility could lead to the latest available prices becoming stale very quickly. Much work may need to be done to keep pricing current.
The Bottom Line
The money market reforms designed to protect investors during times of great uncertainty also come with their share of issues to work through. Nearly $3 trillion is invested in money market funds, much of which is used as a quasi-cash position. The goal of helping to maintain calm during periods of volatility could end up driving shareholders away from these funds altogether.
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