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Loss in “Money” Fund Reminder that All “Safe” Funds Not Created Equal

Even after suffering through the implosion of the tech-stock sector in 2000 and the broad market slump that’s lingered since then, investors had reason to be disturbed by the December 14 article in The Wall Street Journal. A “money market fund,” the newspaper reported under a bold headline, had lost 1.9% of its value, or $47.8 million, in a single day.

Investors have come to regard money market funds as safe havens, of course, since their first mandate is to avoid losing any of their shareholders’ principal. The problem was that this Brinson fund—while positioned as a money market fund to participants in at least one company’s 401(k) plan (BP PLC), according to the Journal—was actually a “cash management” fund. Also known as an ultrashort bond fund, these funds invest primarily in short-term debt securities that carry relatively little interest-rate risk.

Although the Brinson fund was far less volatile than stock funds or general bond funds—this was its first significant loss in its 20-year history—it wasn’t a true money market mutual fund of the sort that most investors think of when they see the words “money” and “fund” in the same name. That’s because it didn’t adhere to the same investment restrictions aimed at minimizing risk. British Petroleum told the Journal that its investment Web site for employees explained that the fund didn’t enjoy the same investment protections as a money market mutual fund, but that didn’t stop some BP employees from being surprised when their accounts showed paper losses in the fund. Nor did it appease some segments of the money market fund industry.

“Equating this fund and a money market fund is like equating apples and oranges,” steams Mike Sheridan, senior portfolio manager and director of investments for Reserve Funds, a New York investment firm credited with launching the first real money market fund and today a specialist in managing such funds. “It’s inappropriate, and hence investors got burned. It highlights the need for better disclosure.”

True money market mutual funds comply with Rule 2a-7 of the 1940 Investment Company Act, which sets strict limits on the types of securities the funds can hold. For example, they can invest only in debt obligations that mature in 13 months or less and must maintain an average weighted maturity for their entire portfolio of no more than 90 days. The funds also must invest at least 95% of their assets in debt obligations with the highest possible credit rating.

Cash-management or ultrashort bond funds also invest in high-grade, short-term fixed income securities, but will sometimes invest deeper on the credit-quality scale or farther out on the yield curve in search of slightly higher returns. The cash-management account profiled in The Wall Street Journal article is formally known as the Brinson Trust Co. U.S. Cash Management Fund. It is managed by Brinson Partners, a unit of UBS AG, which markets its funds to corporate clients but does not market directly to participants in the 401(k) plans of those clients. That marketing is done either by the plan sponsor or its plan administrator.

Included in the Brinson fund’s portfolio in December was commercial paper (short-term debt) of Enron Corp., the Houston-based energy trading company which that month filed for protection from its creditors under Chapter 11 of the U.S. Bankruptcy Code. That filing triggered an inevitable decline in the value of Enron’s commercial paper, which in turn triggered a decline in the market value of the Brinson fund.

True money market funds are allowed to buy commercial paper, provided it is highly rated by credit-rating agencies. However, they may invest only 5% of their assets in the paper of a single issuer, and then only if that issuer has a “tier-1” rating (the highest rating possible). They may invest up to 1% of their assets in the securities of a single “tier-2” issuer. Enron was a tier-2 issuer, says Sheridan. Brinson told the Wall Street Journal that the Enron paper accounted for about 2% of the $2.5 billion of assets in its fund.

For investors seeking preservation of principal in their retirement accounts or elsewhere, the Brinson incident reinforces the need for selecting carefully among the many types of investment options—from true money market funds to stable value funds to ultrashort bond funds—that tout safe returns.

“It’s always good to read the fund’s prospectus,” says David Wray, president of the Profit Sharing/401(K) Council of America. “In the case of money funds, you’re not looking for the highest possible returns, you’re just looking for a place that’s safe, and you want to make sure that’s what you’ve got.” Wray added that most funds advertised as money market funds in 401(k) retirement accounts and managed by well-known investment companies are just that. Again, however, it is incumbent upon investors to know what they’re buying.

There is, of course, one type of fund that allows investors to enjoy the stability of a money market fund and the generally higher returns of an intermediate-term bond fund, and that is a stable value fund. Like intermediate-term bond funds, stable value funds routinely invest in high-grade shorter-term debt securities. Unlike intermediate-term bond funds, however, they wrap those securities in an insurance company guarantee, or “wrap contract,” which assures investors that they will always be able to redeem their shares at book value, regardless of short-term fluctuations in the underlying portfolio. If the fund itself cannot pay full value on shareholder redemptions, the wrap issuer is obligated to step in and make up the difference. (Some stable value funds also invest in guaranteed investment contracts, which offer comparable protection for investors.)

John Kowalik, senior vice president, portfolio manager and head of investment-grade fixed income investments at Oppenheimer Funds, says it is telling to compare what would happen to a stable value fund if its underlying investment portfolio were to lose 2% of its value in a single day, as happened with the Brinson fund. Under such a scenario, he says, investors in the stable value fund would not realize that 2% loss, even if they withdrew their shares the next day. It would be possible, he conceded, that they would experience lower returns on their shares going forward, as that loss was amortized over a period of time (a process handled through reductions in the fund’s crediting rate). However, the value of their shares would not have declined.

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