Updated: Apr 13, 2019
Constant NAVs were fine. Except for what lay beneath.
Regulators cannot be happy with a lack of transparency anywhere in the financial sector. So, to have a product out there with a stated NAV which is higher than the actual NAV was not going to last forever.
It got tested thoroughly in September 2008 when a money market fund by the name Reserve Primary Fund “broke the buck”: its NAV went below the Constant of one dollar. This happened primarily because of the investment by that fund in Lehmann paper. It was not a whole lot: it was just 1.15% or thereabouts of the total assets of that Fund.
However, it was enough to make the NAV drop, in a category of funds that are only supposed to tick upward, one day at a time.
The Money Market Fund Regulation (as also the USA Money Market Reform of October 2016) does not do away with Constant NAV Funds.
It merely requires that all funds also parallelly declared the NAV as determined by market-based valuation methods (as opposed to the Amortised Cost Method used by Constant NAV Funds.)
This means that an investor has ongoing information on the gap between the Constant NAV and the floating or market valuation based NAV. This transparency is intended to guide and inform investors.
The Constant is what you want it to be; the truth is the actual NAV based on market valuations. Enter: the hedge fund.
Transparency can also provide investors the opportunity to move in for a “kill”. Pick a day when the market-based NAV is lower than the Constant NAV by enough; and make a redemption. That is what hedge-fund types do for a living and discovering this opportunity is inevitable.
Of course, the variation between the Constant and the market valuation based NAV cannot exceed threshold levels. When that level is breached transactions are conducted at market valuation based NAVs and not the Constant.
But a half basis point short of that threshold the strategy is valid. That is a very fine edge to finesse – but then, we are talking hedge funds: they thrive in living on the edge.
Fund Managers under MMFR are expected to “know” their investors. Is any one investor holding too many units? Is any one investor-type over-represented? (It does not actually say that – but it does ask: what kind of investors are likely to redeem investments in tandem?)
The Money Market Fund industry has a large proportion of institutional investors. Most of them use money market investments to handle liquidity; either surpluses; or to keep money at hand for opportunities and emergencies. But hedge funds, too, use money market funds for precisely the same reasons: with the added nose for smelling out opportunities such as this one.
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