Paying for the privilege of capital preservation is not an unusual practice in times of heightened uncertainty. This year investors have been willing to pay a fee in the form of negative yields to the German and Swiss governments in order to access a safe short-term parking place for their money. While one can argue endlessly as to whether the rationale behind these money flows is sound, what is clear is that these investors were fully cognisant of the terms of the trade. In other words, they were happy to lose a bit of money in order to preserve the bulk of it. However, a totally different situation arises when investors engage in capital preservation strategies not expecting to lose capital and end up unwittingly doing so. This may have been the case for investors in some European EUR-denominated money market exchange-traded-funds (ETFs).
Some money market ETFs have effectively become “capital-eroding” investment propositions
A large swathe of investors in money market funds do not seek a financial reward, but rather a near risk-free vehicle in which to park cash during periods of transition or uncertainty in their asset allocation decision-making process. But they generally do so under the assumption that returns after fees should ideally marginally beat, or at least equal, those obtained by placing cash in a bank deposit. In fact, for these investors the worst case scenario would be for zero returns after management fees (note – we are speaking in terms of nominal returns, inflation is not factored in). Very few, if any, would consider the possibility of negative returns. After all, money market funds are designed to keep a constant net asset value (NAV), aren’t they? While most traditional money market funds do (for the time being, at least), money market ETFs are not like traditional funds.
Beware of Money Market ETFs
Money market ETFs aim to replicate the performance of the money market, but they do so on a variable NAV basis, with performance mirroring that of a common money market index. This didn’t pose much of a problem in the pre-crisis years – in fact, money market ETFs attracted good flows by virtue of charging lower management fees vs. traditional funds. However, the progressive deterioration of financial market conditions in the eurozone, particularly in 2012, means that some money market ETFs have effectively become “capital-eroding” investment propositions from the get-go and they are delivering negative returns net of management fees. This could be something of an unwelcome surprise for investors operating under the belief that, irrespective of structure, money market funds cannot pass on losses.
In order to fully preserve capital in the current environment you are going to have to look beyond run-of-the-mill money market ETFs
There is not a standard way of measuring money market performance and this is reflected in the various strategies ETF providers follow. Providers of synthetic replication money market ETFs generally choose to replicate the return of a rolling deposit invested daily at EONIA (i.e. the overnight reference rate for the euro computed as a weighted average of all overnight unsecured lending transactions undertaken in the banking system). Meanwhile, providers of physical money market ETFs tend to replicate the return of indices made up of government securities with very short-term maturities (i.e. bills or bonds with residual maturity of up to one year). Some providers of physical replication ETFs focus solely on German government issues while others offer ETFs tracking very short-dated government securities from across the eurozone.
The Money Market ETFs Delivering Negative Returns
In the particular case of physical replication money market ETFs tracking German government short-dated paper, we are now seeing some negative returns after management fees for the year. For example, according to Morningstar data, the iShares eb.rexx Money Market (EXVM) and the ETFlab Deutsche Borse EuroGov Germany Money Market (EL4W) returned -0.06% and -0.09% respectively, from the beginning of the year to the end of August. This is the result of the aforementioned negative yields carried by German short-dated government paper. This situation may remain in place for some time to come irrespective of potential purchases of peripheral short-dated government bonds by the European Central Bank (ECB).
Once you factor in the effects of inflation to calculate real returns, the overall capital losses delivered by these German-centric money market ETFs will be higher. However, on this point it is worth noting that according to Morningstar data, while YTD returns after management fees for the bulk of non-German-centric money market ETFs were positive out to the end of August, real returns would have been negative. This is hardly surprising given the times we live in. Ultra-low yields from the safest government bonds and capital losses from the eurozone periphery ones have proved an ungrateful combination for physical replication money market ETFs tracking pan-eurozone indices. Meanwhile, the extreme impairment of the eurozone inter-banking market has shifted the EONIA tracking path downwards. It historically mirrored the ECB main refinancing rate, which is currently at 0.75%, but it now tracks the lower deposit rate, which currently stands at a big fat zero! This is translating into very low returns for EONIA-based synthetic money market ETFs, which remain the most popular with money market investors based on assets under management.
There are two key messages to be taken from all this. First, never assume that what applies to traditional mutual funds must also apply to ETFs. Second, in order to fully preserve capital in the current environment you are going to have to look beyond run-of-the-mill money market ETFs.
Coming Up: Morningstar ETF Invest Conference Europe 2012
Thought Leadership from the Leaders in the ETF Space
Morningstar’s Inaugural ETF Invest Conference Europe will feature some of the sharpest minds in ETF management and top pundits to help sort out the complexities, alternative theories, and investing strategies using ETFs. The event features keynote presentations, and general discussions, on key areas of strategic and tactical investing solutions. The conference will also give you the opportunity to develop and expand your professional network by conversing with fund managers, analysts, providers, and other financial industry experts.
For full details visit the conference web site here.
