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Ideally, transparent markets make better markets. In some cases, though, when certain market participants have a disproportionate amount of power, transparency ends up benefiting certain investors at the expense of others.
That fundamental idea is at the heart of a debate currently going on in an important corner of the financial markets. At issue is whether money market mutual funds should disclose the value of their assets on a daily basis and the possible impact on fund companies and investors of all types.
Money-market mutual funds: A systemic risk?
Ever since the financial crisis, money market mutual funds have worried regulators. With one major fund having had to liquidate during the crisis at less than the traditional $1-per-share price that funds target, and with the government having had to provide guarantees for money funds for years following the crisis, the SEC has looked at numerous ways to try to prevent similar disruptions from occurring. These included the draconian solution of forcing money market mutual funds to have floating share prices, which would have rendered the funds basically unusable for most investors.
In an effort to avoid that harsh level of regulation, many money market fund companies have voluntarily started providing daily disclosure of the true net asset value of their funds. Although Goldman Sachs (NYSE: GS ) , JPMorgan Chase (NYSE: JPM ) , and Federated Investors (NYSE: FII ) cater largely to institutional investors for whom such technical information is commonplace and readily understood, what's arguably more surprising is the fact that some other companies that run money market funds for retail investors have followed suit. Fidelity and Schwab (NYSE: SCHW ) , which have huge client bases with millions of ordinary investors using their money funds, have started disclosing these figures as well.
The smart holdout
One company that hasn't gone along with the crowd, though, is investor-owned Vanguard Group. Vanguard argues that its retail investors haven't asked for such technical information, and moreover that the fluctuations at its flagship Prime Money Market Fund have been relatively small.
But there could be a much bigger benefit from not disclosing figures on a daily basis. By doing so, money funds avoid potential manipulation from large institutional investors seeking to take advantage of tiny fluctuations in prices.
A simple example
Under current practice, investors are allowed to buy or sell as many shares of money funds as they want at a constant price of $1 per share. For most investors, the fact that those shares might actually be worth $1.0001 or $0.9999 isn't very important; the small disparities don't add up to much on typical retail account sizes.
But for institutions, profiting from tiny disparities is part of their business model. With precise information about money fund values, institutions can take advantage of less sophisticated money-fund investors by performing arbitrage-based transactions. Here's how it would work:
- When a money fund NAV is above $1, institutions would buy fund shares and sell commercial paper on the open market. With interest from the money fund calculated on a slightly higher share value, institutions would end up slightly ahead.
- Conversely, when NAV falls below $1, institutions would sell shares for $1 and buy commercial paper at a slight discount. Again, the profits would be small, but on large balances, they would amount to real money.
Worst of all, repeated application of these purchases and sales could eventually put the fund at risk, creating downward pressure on share prices. The net impact would be to funnel wealth to the institutions for whom these small disparities would add up to enough to justify using the strategy.
Holding the line
It may seem uncharacteristic of Vanguard to avoid making its money funds transparent. However, if doing so protects ordinary investors from manipulative practices of institutions seeking to take advantage of them, then I think everyone should support Vanguard's decision.
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