On July 23, the SEC voted in a set of long-debated reforms to the rules governing money market funds (MMFs). The reforms, which will take effect in 2016 to allow managers and investors time to adapt, are aimed at preventing a replay of the dangerous 2008 run on MMFs triggered when the Reserve Primary Fund “broke the buck”. While the two-year implementation delay means investors need not take immediate action, we recommend investors currently in an institutional prime or tax-exempt MMF select different “cash” vehicles, such as government MMFs, well ahead of time to avoid potential liquidity issues.

In 2016, institutional “prime” MMFs (which can own commercial paper, bank CDs, and other securities) and institutional municipal MMFs (which can own tax-exempt municipal paper) will migrate to a variable pricing framework intended to reflect underlying securities’ actual market values. With nearly $1 trillion between them, these two categories hold 38% of all MMF assets. Funds restricted to holding only government-related paper (which we refer to as Treasury MMFs), and MMFs of all kinds that target retail rather than institutional investors, will continue to use amortized-cost pricing.

In addition to requiring sponsors of MMFs to perform refined stress tests—including minimum holdings of liquid assets—and to upgrade systems to provide more transparent disclosure and reporting, the key features of the reform for investors are as follows:

• Institutional prime and municipal MMFs will float their net asset values (NAVs) based on underlying security market valuations.
• All MMF boards will have discretion to impose redemption gates extending up to 10 days in any 90-day period, and redemption fees of up to 2% when “weekly liquid assets” (securities that the fund can sell for cash within one week) fall below 30% of assets.
• MMFs must automatically impose a 1% redemption fee if “weekly liquid assets” fall below 10%, unless the fund’s board determines a higher or lower fee is in the best interests of the shareholders.
• Retail funds, now defined as having policies and procedures designed to limit shareholders to natural persons, will remain exempt from the floating NAV rule.
• Treasury MMFs are exempt from all these rules but may opt in to the gating and redemption fee provisions. Treasury MMFs are now defined as those investing at least 99.5% of assets in government securities (including Treasury repurchase agreements), up from 80% today.

The effectiveness of these new rules will not be known until they are tested in a liquidity crisis. The principle change of variable pricing is aimed at institutional funds with corporate-credit exposure, because that is where the risk of runs is deemed greatest. In the 2008 crisis, institutional shareholders fled prime MMFs in an attempt to avoid losses by exiting at the full price (recognizing that some funds’ underlying assets were tainted). But with gating provisions and redemption fees overhanging funds, shareholders in a future crisis would still have an (admittedly reduced) incentive to redeem quickly if they saw a deterioration in NAVs, to avoid being gated or paying redemption fees in case the liquid assets thresholds were breached.

No doubt funds will improve the ratio of liquid assets, though probably at a cost of lower yields. However, the prospect of the new floating pricing leading to large outflows by 2016 from institutional investors may in turn induce others to reduce exposure to avoid the risk of being gated or penalized. With returns on MMFs sitting at just about zero for more than five years, total assets invested have dwindled 35% from their peak level in January 2009 and now total $2.6 trillion, of which about $1 trillion is in institutional prime and municipal MMFs affected by the new variable NAV pricing. Estimates for future post-reform outflows from these funds have ranged from $300 billion to $500 billion, based on data from Barclays and Bank of America Merrill Lynch, as institutional investors requiring a fixed NAV seek alternatives such as Treasury MMFs.

For investors who wish to continue to use MMFs (a perfectly reasonable choice, in our view), returns may be further pressured by higher fees as compliance and reporting burdens increase.

For investors whose charters or regulations mandate fixed NAVs, Treasury MMFs remain a suitable option, even though yields are perpetually a bit lower than those of “prime” funds. These funds are a good option for other investors as well, given the implied illiquidity and exit penalty risk now inherent to MMFs. Large institutional investors can also consider purchasing short-dated T-bills directly. Other, better-yielding potential substitutes include FICA or similar products that invest in packets of government-insured sub-$250,000 bank deposits. Additional new products could evolve over the next two years to offer MMF-like characteristics without the gating and fee penalty risks. In the meantime, prudence would counsel moving away from MMFs that own lower-quality securities and have low levels of liquid assets.

Stephen Saint-Leger is a Managing Director on the Cambridge Associates Global Investment Research team.