Sturm Und Drang In Money Market Funds - When Money Market .

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Sturm und Drang in Money Market FundsWhen Money Market Funds Cease to Be NarrowStephan Jank & Michael Wedow(University of Tübingen & Deutsche Bundesbank & European Central Bank)Atlanta, Financial Markets ConferenceAtlanta, April 10 2012The presentation represents the authors’ personal opinion and not necessarily those of the Deutsche Bundesbank or theECB.

Introduction“Money market funds are boring, but safe.”(Morningstar.de 08/16/2002)Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 20122 / 27

Motivation: Why are Mutual Funds Interesting?Similarity of Banks and Mutual Funds: Withdrawals are costly (liquidity-based trading). It takes time to restore cash balance remaining investors bear most of the costs. negative externality.Edelen(1996), JFE; Nanda, Narayanan & Warther(2000), JFE The negative externality increases if assets are less liquid. Expectation that other investors will withdraw “self-fulfilling run”Diamond & Dybvig (1983), JPEMutual funds give us a setting to test hypotheses about strategiccomplementarities.e.g. Goldstein & Pauzner (2005), JF; Chen, Goldstein and Jiang (2007)Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 20123 / 27

Motivation: Why are Money Market Funds Interesting? Maturity intermediation bank runs Solution: deposit insurance Deposit insurance moral hazard Solution to the dilemma: reduction of maturity gap “narrow banking” Money market funds (short-term, high-grade debt) narrow banksAre money market funds immune to market-wide liquidity shocks?RunA drop in market-wide liquidityleads to outflows.Safe HavenA drop in market-wide liquidityresults in inflows. Studies using aggregate US data support the “safe haven” hypothesis.Gorton & Pennacchi (1992); Miles (2001), JEF; Pennacchi (2006), JME;Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 20124 / 27

5 4Excess Return (%) 3 2 101Motivation: Excess Return of German Money Market Funds1996m11998m12000m12002m1Time75th PercentileMedian2004m12006m12008m125th PercentileFigure: MMFs’ Excess ReturnJank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 20125 / 27

Institutional BackgroundUnited StatesGermany Introduction in the 70s Introduction in the mid 90s Total assets: Total assets:3,107.1 billion USD26.8 billion EUR 25.8 % of mutual fund assetsICI Factbook (End of 2007) 7.6 % of mutual fund assetsDeutsche Bundesbank (End of 2007) Maximum maturity: 1 year Maximum maturity: 1 year Weighted average maturity: Weighted average maturity:(85 % of assets)90 daysno restriction(SEC) Implicit insurance of issuer“never break the buck”InvG No implicit insurance Floating NAV Constant NAVJank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 20126 / 27

SampleProportion of Assets.2.4.6.8Survivorship-bias-free sample of all German retail money market fundsNumber of funds: 49Sample period: 1996/01 - 2008/06 (1999/01 - 2008/06)Assets: Euro denominated assets0 199619982000Debt SecuritiesBank DepositsOther AssetsJank & Wedow (2012)2002Year200420062008Commercial PapersTreasury SecuritiesSturm und Drang in Money Market FundsApril 10 20127 / 27

Performance Persistence: Repeat Winners and Losers Who are the winning funds and do they repeat? Performance persistence of MMFs is usually very high. First-order autocorrelation of annual excess return: 0.54 Now: a detailed view.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 20128 / 27

Performance Persistence: Repeat Winners and LosersYearTotalWinnerWinnerRepeat Winners and 1121314177.665375545210Odds 683.98-1.02Pearson’s pλ Test:λ:76.2p-value:0.000 Overall: persistence in performance Years without persistence and reversals also occur :Most winners in 2006 (high liquidity) are losers in 2007 (low liquidity)Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 20129 / 27

The Determinants of Money Market Funds’ ReturnsDeterminants of MMFs’ Returns: Expense ratio (commodity view)Domian & Reichenstein (1998), FSR; Christoffersen & Musto (2002), RFS Riskiness of portfolioKoppenhaver(1999), FRB Chicago ProceedingsAsset Pricing Theory:Illiquid assets outperform in liquid times and underperform in illiquidtimes.Acharya & Pedersen (2005), JFEHypothesis 1:Funds that hold illiquid assets outperform in liquid times andunderperform in illiquid times.Massa & Phialippou (2005)Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201210 / 27

The Determinants of Money Market Funds’ ReturnsMonthly Cross Sectional RegressionsMonthly Cross Sectional Regressions:Excess Returnit β0 β1 Liq. Assetsi,t 1 β2 Sizei,t 1 β3 Expense Ratioi εi,tExcess ReturnitLiq. Assetsi,t 1Expense RatioiSizei,t 1Money market funds’ return minus Bubill rateShare of government securities, bank deposits and commercial papersAnnual expenses/ average assets (fund average)Log of total assets (EUR)Hypothesis 1:Funds that hold illiquid assets outperform in liquid times andunderperform in illiquid times.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201211 / 27

The Determinants of Money Market Funds’ ReturnsMonthly Cross Sectional RegressionsMoney Market LiquidityLiq. Assetst 1Sizet 1Expense RatioConstantObservationsNumber of fundsR2(liquid)1st 0.00766(0.30)895270.1892nd 361(0.27)1000280.2413rd 319(0.33)980280.287(illiquid)4th 1(0.88)949300.202Fama-MacBeth Regression, Fama-MacBeth standard errors in parentheses.*** p 0.01, ** p 0.05, * p 0.10 Funds that hold illiquid assets outperform in liquid times and underperform inilliquid times.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201212 / 27

The Determinants of Money Market Funds’ Returns Money market funds are not a commodity. Fund managers are able to offset expenses and enhance returns by investing in lessliquid assets. Illiquid funds outperform liquid funds in liquid times. Long period of high liquidity (2001-2006) illiquid funds outperform persistently. Enhancing returns widens the narrow structure of money market funds and makesthem vulnerable to runs. How does an illiquidity shock influence money market funds’ flows?Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201213 / 27

Flows of Money Market Funds Withdrawals are costly (liquidity-based trading). Time to restore cash balance remaining investors bear most of the costs. negative externality The negative externality increases if assets are less liquid. Expectation that other investors will withdraw. “self-fulfilling run”Hypothesis 2:In illiquid times funds that hold illiquid assets are more likely toexperience a run than funds that hold liquid assets.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201214 / 27

0 60 8,000Net Flows (%) 40 20Net Flows in Mio. Euro 6,000 4,000 2,0000Net Flows by Portfolio Liquidity (2007/07 - 2008/06)1st Quartile (illiquid)3rd Quartile2nd Quartile4th Quartile (liquid)Figure: Absolute FlowsJank & Wedow (2012)1st Quartile (illiquid)3rd Quartile2nd Quartile4th Quartile (liquid)Figure: Relative FlowsSturm und Drang in Money Market FundsApril 10 201215 / 27

Flows of Money Market FundsNetflowit αi β1 Liq. Assetsi,t 1 β2 Exc. Returni,t 1 β3 Spreadt β4 Spreadt Liq. Assetsi,t 1 β5 Spreadt Exc. Returni,t 1 β6 Sizei,t 1 β7 Agei,t 1 εi,tNetflowitExcess ReturnitLiq. Assetsi,t 1SpreadtSizei,t 1Agei,t 1Relative net-flows:(inflows - outflows)/total assetsMoney market fund return minus Bubill rateShare of government securities, bank deposits and commercial papersMoney market spreadLog of total assets (EUR)Age in years since inceptionHypothesis 2:In illiquid times funds that hold illiquid assets are more likely toexperience a run than funds that hold liquid assets.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201216 / 27

Flows of Money Market 0.13)30.08***(10.95)YesNo3687440.033Netflowt 1Liq. Assetst 1Exc. Returnt 1SpreadtSpreadt * Liq. Assetst 1Spreadt * Exc. Returnt 1Sizet 1Aget 1ConstantFund DummiesTime DummiesNo. of Obs.No. of FundsWithin R .292**(0.13)32.40***(10.25)YesNo3687440.043Fixed Effects Regression, robust standard errors clustered by fundin parentheses. *** p 0.01, ** p 0.05, * p 0.10 Significant performance-flow relationship. Flows following an illiquidity shock differ across liquid and illiquid funds.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201217 / 27

10 5Marginal Effect051015Marginal Effect of Market Illiquidity on Net Flows0.1.2.3.4.5.6Share of Liquid Assets.7.8.91A market illiquidity shock leads to. significant outflows, if the share of liquid assets is small (Run) no significant outflows, if the share of liquid assets is large enough (Safe Haven)Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201218 / 27

Conclusion: Sturm und Drang in Money Market Funds Fund managers have an incentive to enhance their returns. Illiquid funds outperform liquid funds as long as market-wide liquidity is high. Investing in less liquid assets widens the narrow structure of money market funds. Investors react to good and bad performance of money market funds. Following an illiquidity shock we observe runs on illiquid/enhanced funds.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201219 / 27

Recent regulatory developments in Europe concerning Money Market Funds CESR guidelines on a common definition of European money market funds (May2010). Two tiered approach with objective of investor protection Distinction through very short and longer weighted average maturity Short Term MMF Only investments in highest quality assets: two highest available short-term creditratings. Ensure its portfolio has a weighted average maturity (WAM) of no more than 60 days. Ensure its portfolio has a weighted average life (WAL) of no more than 120 days. Residual maturity until the legal redemption date of less than or equal to 397 days. Constant or a fluctuating net asset value Longer Term MMF Only Fluctuating NAV May invest in sovereign issuance of at least investment grade quality. Residual maturity until the legal redemption date of less than or equal to 2 years. Weighted average maturity (WAM) of no more than 6 months. Weighted average life (WAL) of no more than 12 months.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201220 / 27

Appendix: Summary StatisticsExcess ReturnRel. Net FlowDebt SecuritiesCommercial PapersTreasury SecuritiesOther AssetsBank DepositsAgeSizeExpense eDatastreamBBKBBKBBKBBKBBKBBKBBKBBKBVISample: 1999:01-2008:06Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201221 / 27

Appendix: Persistence of Returns: First-Order AutocorrelationSample Period:Exc. Returnt 1ConstantNo. of Obs.No. of YearsR21995 - )359120.34815260.33520760.362Fama-MacBeth standard errors are given in parentheses. *, **, and ***indicate significance at the 10%, 5% and 1% level respectively.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201222 / 27

Appendix: First-Order Autocorrelation: Excess Return & Expense RatioPanel A: Year 2006Expense RatiotExpense Ratiot 1ConstantR21.019***(0.10)0.0107(0.06)0.86Exc. Return tExc. Return t 1Constant0.972***(0.23)-0.846*(0.48)R20.49Panel B: Year 2007Expense RatiotExpense Ratiot 1ConstantR21.184***(0.19)-0.11(0.09)0.77Exc. Return tExc. Return t 1Constant-0.481(0.47)-5.145***(1.33)R20.03Robust standard errors are given in parentheses. *, **, and *** indicate significanceat the 10%, 5% and 1% level respectively.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201223 / 27

The Determinants of Money Market Funds’ ReturnsFixed Effects RegressionFixed Effects Regression:Excess Returnit αi β1 Liq. Assetsi,t 1 β2 Spreadt β3 Spreadt Liq. Assetsi,t 1 β4 Sizei,t 1 εi,tExcess ReturnitLiq. Assetsi,t 1Sizei,t 1Money market funds’ return minus Bubill rateShare of government securities, bank deposits and commercial papersLog of total assets (EUR)Hypothesis 1:Funds that hold illiquid assets outperform in liquid times andunderperform in illiquid times.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201224 / 27

The Determinants of Money Market Funds’ ReturnsFixed Effects Regression(1)(2)1999-2006Exc. Returnt 1Liq. Assetst readtSpreadt * Liq. Assetst 1Sizet 1ConstantNo. of Obs.No. of FundsWithin R 0.70(0.93)4046490.192Fixed Effects Regression, robust standard errors clustered by fund in parentheses.*** p 0.01, ** p 0.05, * p 0.10 Share of liquid assets matters! Omitted variable bias The influence of liquid assets varies as a function of market-wide liquidityJank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201225 / 27

Appendix: The Determinants of Money Market Funds’ ReturnsRobustness Check: 2SLS(1)Liq. AssetstSpreadtSpreadt * Liq. AssetstExc. Returnt 1SizetNo. of Obs.No. of 492SLS fixed effects regression, robust standard errors clustered by fund in parentheses.*** p 0.01, ** p 0.05, * p 0.10 Liq. Assetst is instrumented by its first and second lag.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201226 / 27

Appendix: Flows of Money Market FundsRobustness Check: 2SLSFlowt 1Liq. AssetstExc. ReturntSpreadtSpreadt * Liq. 88)-11.28***(3.460)40.39***(14.87)Spreadt * Exc. ReturntSizetAgetFund Fixed EffectsTime Fixed EffectsNo. of Obs.No. of *(0.522)30.23*(15.76)YesYes3639442SLS fixed effects regression, robust standard errors clustered byfund in parentheses. *** p 0.01, ** p 0.05, * p 0.10 Liq. Assetst , Exc. Returnt and Sizet are instrumented by their first and second lag.Jank & Wedow (2012)Sturm und Drang in Money Market FundsApril 10 201227 / 27

Conclusion: Sturm und Drang in Money Market Funds Fund managers have an incentive to enhance their returns. Illiquid funds outperform liquid funds as long as market-wide liquidity is high. Investing in less liquid assets widens the narrow structure of money market funds. Investors react to good and bad performance of money market funds.

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