New research from a Bank of Canada economist finds that money market mutual funds that maintain constant net asset values (NAVs) are more vulnerable to runs than funds that have variable NAVs. Still, that doesn’t mean that constant NAV funds should be abandoned, it notes.
The new paper by Jonathan Witmer, of the Bank’s financial markets department, examines the vulnerability of constant NAV funds (which prevail in the U.S.), and variable NAV funds, to investor runs.
Using daily data on individual fund flows from countries that have both constant and variable NAV funds, the paper finds, “Preliminary evidence suggests that funds with a constant NAV are more likely to experience sustained outflows, even after controlling for country fixed effects and other factors.”
However, it also observes that constant NAV funds are less likely to be liquidated after periods of large outflows, which is consistent with the theory that constant NAV funds receive additional implicit support from fund sponsors. Indeed, it says the fact that constant NAV funds are less frequently liquidated after a period of heavy redemptions, suggests there’s an implicit guarantee for constant NAV funds that doesn’t exist for variable NAV funds.
The paper comes amid an ongoing regulatory debate about whether to do away with constant NAV funds in the wake of the financial crisis, which saw a run on the Reserve Primary fund that forced U.S. policymakers to step in and backstop money market funds.
In terms of policy implications, the paper says the fact that constant NAV funds appear to be more vulnerable to runs doesn’t mean the structure should be scrapped. For one, while the variable NAV structure is less susceptible to runs, it does not fully eliminate run-like behaviour, the paper notes. And, there are other advantages to constant NAV funds that are not considered in the paper, including that the structure may reduce tax, bookkeeping and operational costs for investors; and, that a switch to a variable NAV structure could push investors towards other less regulated vehicles, increasing systemic risk.
Moreover, it notes that there are advantages and disadvantages with the implicit guarantee that constant NAV funds seem to enjoy. It says this “can reduce moral hazard and reduce risk-taking in money market mutual funds, since the fund sponsor would be concerned that the poor performance of the fund may have negative spillovers on the sponsor’s other businesses.”
However, an implicit guarantee is a potential channel for contagion between the banking sector and money market mutual funds, it says, as losses in a money market mutual fund may be passed onto the fund sponsors. And, this could spread in the money market fund sector through a reduction in the value of the implicit guarantee, it adds.