Money Market Funds at the Zero Bound (plus some vice on the side)

I'm treading on FT Alphaville's Izabella Kaminska's turf (see below).

Long time readers may remember one of this article's co-authors, Marcin Kacperczyk, as the co-author of one of our favorite papers "The Price of Sin: The Effects of Social Norms on Markets" which we turned into a virtual cottage industry by periodically checking in on a portfolio of vice-related equities (it outperformed over most time periods)

From VoxEU:

The unintended consequences of the zero lower bound policy for the money market funds industry 

Marco Di Maggio, Marcin Kacperczyk 19 July 2016

The zero lower bound policy for nominal interest rates was implemented to stimulate sluggish economic growth and boost employment. This column explores whether this policy had unintended effects on the money market fund industry. Traditionally enjoying relatively low and safe returns, money market funds could respond to the low interest rate environment by either exiting the market or changing product offerings and accepting higher portfolio risk. The results show evidence of both, and point to an important but neglected channel for monetary policy transmission.

In the aftermath of the Global Crisis of 2007-2008, the US Federal Reserve took an unprecedented decision to lower short-term nominal interest rates to zero, a policy commonly known as the zero lower bound policy. This initial action was followed by a sequence of announcements providing guidance that the short-term rate would stay near zero for a longer period. While several economists have argued that the Fed’s policy exerted a positive impact on the US economy by stimulating sluggish economic growth and boosting employment, some critics pointed out that the policy might have also produced undesired consequences, such as inflation in asset prices, or ill-suited incentives to chase higher yields (e.g. Maddaloni and Peydró 2011 and Jimenez et al. 2014, among others). One important part of the financial system that could be significantly impacted by the long-term low interest rates is the money market fund (MMF) industry.

Money market funds Traditionally, MMFs used to offer relatively low returns for the provision of safety. While this idea has been somewhat shattered by the collapse of the Reserve Primary Fund and the run on MMFs in September 2008 (e.g. Kacperczyk and Schnabl 2013, Chernenko and Sunderam 2014, Strahan and Tanyeri 2015), until then, MMFs had provided investors positive returns, even after paying fees. The consequence of the unprecedented change in interest rates to levels close to zero has been that returns on traditional money market instruments – such as Treasuries, repos, or deposits – declined to similarly low levels. Therefore, any fund investing in these assets was likely to produce negative net-of-fees nominal returns to their investors. It has thus become obvious that such business models cannot be sustained for too long, as money would flow out of funds with negative returns.¹

Such a dire situation has posed a dilemma for money funds. On the one hand, they could accept the situation and keep their risk profiles unchanged. This, however, would force them to first reduce or even waive their fees, and in the end, if the low rates persisted, to exit the market. On the other hand, funds could change their product offerings by shifting their risk into securities with higher interest rates, thus accepting higher risk in their portfolios, an idea referred to as reaching for yield. Increasing fund risk would boost returns and investor flows (e.g. Christoffersen 2001), and would likely prevent funds from exiting the market. The cost of increasing risk would be a higher chance of being run on in the event of distress in the money market industry.

Reaching for yield and exit In recent work, we empirically assess the equilibrium response of MMFs to the low interest rate environment using weekly data on the universe of US prime funds (Di Maggio and Kacperczyk 2016).[2] We exploit both time-series and cross-sectional variation in the data to identify the causal effect of the unconventional monetary policy on MMF strategies. Our main empirical identification comes from an event study analysis of five FOMC announcements, which signalled that interest rates would be kept near zero into the future. These decisions were plausibly exogenous with respect to the funds’ behaviour; hence, they constitute a useful shock. The access to high-frequency fund data allows us to measure empirical effects within short event windows. We compare MMFs' choices of risky product offerings, exit, and expense policy in the fund data.

Our paper sheds new light on the incentives of asset managers to reach for yield –one of the core factors contributing to the build-up of credit that preceded the financial crisis (Rajan 2010, Yellen 2011, and Stein 2013). Popular explanations include competition among fund managers, different preferences for risk, or desire to offset constraints imposed by regulation. We provide a setting in which the incentives to reach for yield are, on the one hand limited by strict regulation; on the other, significantly affected by changes in interest rates and expectations about their future changes....MORE

Here's Ms. Kaminska's most recent post on money market funds, July 12, she has quite a few more going back to the early days of the financial crisis:
Rate cuts and sterling MMFs

Here's one of our posts on the risk premia accorded sin stocks using the now re-named "USA Mutuals Barrier Fund Investor Class Shares", née The Vice Fund, focusing on gambling, alcohol, tobacco, weapons etc:

If Your Choice Is Vice or the S&P 500, Bet on Vice

In yesterday's "SSRN Paper: 'Time-Varying Fund Manager Skill'" I promised we'd be coming back to Imperial College London's Professor Marcin Kacperczyk. Professor K, along with Princeton's Harrison Hong wrote a paper which we noted in a 2007 post "Moral Judgment On 'Sin Stocks' Means Higher Returns For Vice-Friendly Investors".

The paper "The Price of Sin: The Effects of Social Norms on Markets" is available here.
The thing that stands out is, if you use the VICEX mutual fund (1.37% annual expense) as a proxy for the tobacco, alcohol and war businesses, how reliably sin outperforms.

Here are the 6-month, 1-year, 2-year 5-year and 10-year charts vs. the S&P, via Yahoo Finance:

Six Month

One Year

Two Year 

Five Year

Ten Year
 

Just amazing that an anomaly should be so persistent.
I can't wait til they put the marijuana mavens in there.
And sexbots.
Get the whole country blissed out and the fund goes to infinity.Who needs Soma?
Here are the funds' holdings.

"the warm, the richly coloured, the infinitely friendly world of soma-holiday. 

How kind, how good-looking, how delightfully amusing every one was! "

-Aldous Huxley, Brave New World