A Turtle With a Piano on it’s Back

At a recent gathering of neighborhood fathers (ok, it was poker night), the conversation turned to a topic that I have yet to experience first hand: the pinewood derby. For those of you also unfamiliar with the event, it is apparently one of the high points of participation in the Boy Scouts and involves the racing of small cars created out of blocks of wood.

I, never having participated in the Boy Scouts, made what was later deemed to be a faux pas when I tried to equate the pinewood derby with the soap box derby. The soap box derby, I was told, involves larger vehicles that bigger kids actually sit in and drive down a hill. My gaffe apparently touched a nerve as even the much smaller pinewood derby cars (ok, ok, I get it – you can’t sit in one) take up hours and hours of time in the creation process.

My new enlightenment regarding the cars and pursuits of adolescents inspired me to tackle one of my favorite topics: money market and stable value funds.

Recently I postulated that the upside of stable value funds might shrink over the coming years due to the many barriers and hurdles the managers of these funds now face. Even more recently I attended an industry conference where a stable value manager somewhat angrily dismissed claims like mine and instead insisted that stable value funds will continue to enjoy the same traditional level of outperformance (roughly 1.5%) vs. their main competition (money market funds). Most recently (this morning) I finally had a chance to sit down and thoroughly read the final changes to rule 2a-7 put in place by the SEC. These changes will go in to effect on May 5, 2010. The final rules were made public on March 4, and I hold out the fact that it took me a couple of weeks to stare at them in detail as the only evidence that I have a life outside the office. Yes, the evidence is weak.

With all of that as a backdrop, I can now say with a fair amount of conviction and only a trace of regret that I was right even when I was likely wrong. The new constraints on stable value funds will impact their absolute returns even as drag and resistance slow a soap box – or pinewood – racer. I will, however, concede that I had underestimated the large chunks of wood that the SEC has thrown on to the money market track. Stable value funds will likely continue to outperform their money market competition by the traditional 1.5% percent margin but future outperformance has more to do with what the SEC is doing to money market funds and less to do with the prowess of stable value managers.

What did the SEC do? Perhaps a better question is why did the SEC do anything? Prior to the 2008 crisis it was, for better or worse, considered a given that an investment in a money market fund was made a $1 per share and would be redeemed at $1 a share. The 2008 market chaos, which included the “breaking of the buck” for a prominent money market fund, changed the landscape. The ensuing crisis of confidence affected the public and, I suspect, the regulators who looked more closely at the underpinnings of these funds through the now concluded Treasury Temporary Guarantee Program for Money Market Funds.

As to what the SEC did: money market funds will now be forced to have an average weighted maturity of no more than 60 days (90 days was the prior limit). Additionally, taxable funds will be forced to maintain at least 10 percent of their assets in cash or cash equivalents on a daily basis. Finally, credit quality standards have been raised, and investment in longer term, floating rate products is essentially over.

Many people invest in money market funds because of the perceived stability of that investment. It’s this stability that may leave them content to continue to use money market funds even when they have paid little to no interest in almost a year. In the past, these down cycles in interest have been offset with periods of greater returns (not “great” but at least better) that accompany hikes in short term interest rates. Whether investors like it or not, these new regulations will prevent money market funds from paying substantially more than the current levels even in a rising rate environment.

Soap box racers, when launched from atop a small hill, achieve speeds of up to 35 miles per hour before they slow to a stop. Pinewood derby cars, when launched from the tallest point of a small track, achieve top speeds of not-very-much before they too come to stop at the far end of the track. Neither of these vehicles can take you anywhere in a hurry, and neither have an engine that can climb a hill or achieve great distance.

Stable value funds are soap box racers that now face constraints that will limit their top speed. Our money market funds will soon have the performance attributes of a pinewood derby car dressed up as a turtle, with a smallish piano on its back. I haven’t read the official pinewood derby rule book as of yet, but this does not sound like a winning configuration.

*Originally posted March, 2010.