Here's a statement of the obvious: The opinions expressed here are those of the participants, not those of the Mutual Fund Observer. We cannot vouch for the accuracy or appropriateness of any of it, though we do encourage civility and good humor.
Despite the rather dull title, this is a good one about how assets in your safer funds such as money market ones can be lent out to much riskier ones like high yield bond funds and the legal implications of that.
The transactions between MMFs and equity (or bond) funds to provide liquidity for the latter bear a superficial resemblance to security trades between funds in the same family. When one fund wants to sell a stock and a sibling wants to buy it, they trade between themselves, cut out the middleman, and everybody wins. But in that situation, unlike here, the benefits are symmetric - each is avoiding (half) the brokerage/spread cost. Also there is no risk involved.
A different analogy might be where a fund sponsor props up a MMF by pumping money into the fund. (In the column, MMFs are effectively propping up equity/bond funds by providing liquidity.) A sponsor does this voluntarily, presumably because it figures it is getting something of equal (or better) value - the stability of the MMF that would otherwise break a buck and collapse costing the sponsor reputation and loss of AUM.
In contrast, here the lending MMF appears to be receiving less value than it is giving up (i.e. it is getting less than market rate on its loans). It's not "mutually beneficial" as asserted by a chief risk officer in the closing paragraph who ought to know better. The MMF is certainly getting a higher return than it would on its portfolio, but that return is not commensurate with the additional risk it is assuming. That's what the market rate says.
@MSF You're right about the different kinds of transactions. The interesting thing about this kind of lending is that from a legal perspective two mutual funds even if they're run by the same manager are separate investment companies so the fact that one can lend to the other to help the other out is rather strange. It would be like if Apple decided to give Microsoft a loan to help it through a difficult period of time.
"The interesting thing about this kind of lending is that from a legal perspective two mutual funds even if they're run by the same manager are separate investment companies ..."
How deep into the weeds do we want to go?
These days, many funds are structured as separate series of a common trust. For example, Fidelity Contra (FCNTX) is a series of a trust containing FCNTX, FNITX, FVWSX, and FAMGX.
While Fidelity funds are generally organized as Massachusetts trusts, most series trusts are Delaware trusts. Here's a somewhat old (Feb 2009) but likely still accurate description of Delaware trusts. On p. 3 is a section entitled "Is a Series of a Delaware Statutory Trust Functionally a Separate Legal Entity?" The authors note that the law isn't crystal clear, but that various facts they present lead "the authors to conclude that a series of a Delaware statutory trust is not a separate legal entity and does not possess many of the characteristics often associated with separate legal entities."
Of particular note for Delaware trusts is that the "ability to limit the liabilities of a series is not an inherent attribute of a series—it is only available to statutory trusts that comply with the requirements of Section 3804(a)." Of course virtually all mutual fund series trusts do comply with the legal requirements. But this raises the interesting possibility that if fund A (MMF) lends cash to fund B (stock/bond fund) in the same trust, then the lender might not be assuming more risk. It might have already been on the hook for B's debts, even before lending money.
The Delaware doc cited observes that "the limitation of interseries liability provided in Section 3804(a) has not been interpreted by any Delaware court, so whether equitable or other exceptions are applicable is unclear." In plain English, even though funds may comply with the statute to keep each fund's liabilities separate, there may nevertheless be reasons why a court would hold fund A liable for fund B's debts.
You'll find the same sort of formalities for Massachusetts trusts explained in the Contra SAI I linked to above. There it says that "Under Massachusetts law, shareholders of such a trust may, under certain circumstances, be held personally liable for the obligations of the trust. Each Declaration of Trust contains an express disclaimer of shareholder liability for the debts, liabilities, obligations, and expenses of the trust or fund."
Bottom line is the same as in your column: if anything goes wrong, “It will be a bonanza for the lawyers.” That's even before one gets to a fund lending another money.
Comments
The transactions between MMFs and equity (or bond) funds to provide liquidity for the latter bear a superficial resemblance to security trades between funds in the same family. When one fund wants to sell a stock and a sibling wants to buy it, they trade between themselves, cut out the middleman, and everybody wins. But in that situation, unlike here, the benefits are symmetric - each is avoiding (half) the brokerage/spread cost. Also there is no risk involved.
A different analogy might be where a fund sponsor props up a MMF by pumping money into the fund. (In the column, MMFs are effectively propping up equity/bond funds by providing liquidity.) A sponsor does this voluntarily, presumably because it figures it is getting something of equal (or better) value - the stability of the MMF that would otherwise break a buck and collapse costing the sponsor reputation and loss of AUM.
In contrast, here the lending MMF appears to be receiving less value than it is giving up (i.e. it is getting less than market rate on its loans). It's not "mutually beneficial" as asserted by a chief risk officer in the closing paragraph who ought to know better. The MMF is certainly getting a higher return than it would on its portfolio, but that return is not commensurate with the additional risk it is assuming. That's what the market rate says.
I wonder how the SEC rationalizes its approvals.
How deep into the weeds do we want to go?
These days, many funds are structured as separate series of a common trust. For example, Fidelity Contra (FCNTX) is a series of a trust containing FCNTX, FNITX, FVWSX, and FAMGX.
While Fidelity funds are generally organized as Massachusetts trusts, most series trusts are Delaware trusts. Here's a somewhat old (Feb 2009) but likely still accurate description of Delaware trusts. On p. 3 is a section entitled "Is a Series of a Delaware Statutory Trust Functionally a Separate Legal Entity?" The authors note that the law isn't crystal clear, but that various facts they present lead "the authors to conclude that a series of a Delaware statutory trust is not a separate legal entity and does not possess many of the characteristics often associated with separate legal entities."
Of particular note for Delaware trusts is that the "ability to limit the liabilities of a series is not an inherent attribute of a series—it is only available to statutory trusts that comply with the requirements of Section 3804(a)." Of course virtually all mutual fund series trusts do comply with the legal requirements. But this raises the interesting possibility that if fund A (MMF) lends cash to fund B (stock/bond fund) in the same trust, then the lender might not be assuming more risk. It might have already been on the hook for B's debts, even before lending money.
The Delaware doc cited observes that "the limitation of interseries liability provided in Section 3804(a) has not been interpreted by any Delaware court, so whether equitable or other exceptions are applicable is unclear." In plain English, even though funds may comply with the statute to keep each fund's liabilities separate, there may nevertheless be reasons why a court would hold fund A liable for fund B's debts.
You'll find the same sort of formalities for Massachusetts trusts explained in the Contra SAI I linked to above. There it says that "Under Massachusetts law, shareholders of such a trust may, under certain circumstances, be held personally liable for the obligations of the trust. Each Declaration of Trust contains an express disclaimer of shareholder liability for the debts, liabilities, obligations, and expenses of the trust or fund."
Bottom line is the same as in your column: if anything goes wrong, “It will be a bonanza for the lawyers.” That's even before one gets to a fund lending another money.