Are ETFs 'Poaching' the Market?

By Murray Coleman

While short-duration funds have been all the rage lately in fixed-income ETFs, only one so far invests like a real money market -- the WisdomTree U.S. Current Income Fund (USY). But at least one other is on the horizon and industry observers believe more are on the way.

None of these funds, however, will be able to call themselves actual money markets just yet. That's a fact that may keep investors away, as the term "money market" implies a level of security that most have come to expect. At stake is some $3.5 trillion in assets now parked in money market mutual funds.

Bean-Counting Dilemma

At the crux of the issue is compliance to the Investment Company Act of 1940, and more specifically, to Rule 2a-7. The regulation governs what is and is not a money market fund -- what it can and can't invest in as well as the risks it can take.

Rule 2a-7 also allows for certain accounting procedures that make daily record keeping possible through a mutual fund structure to keep NAVs at stable values. Most money market funds, after all, are launched with a NAV of $1/share-a value that never budges over time. There is an implicit guarantee from the fund company that the funds will never 'break the buck'; that is, that the fund company will make safe enough investments that the funds' value will never dip below the set $1/share.

With an ETF's unique creation and redemption process, avoiding breaking the buck has become an accounting nightmare, says Peter Crane, president of Crane Data LLC.

"Right now, ETFs are beginning to hover around the edges of money market mutual funds," he said. "But they're not the same thing as money market mutual funds. The seeming simplicity of maintaining a stable value is actually a formidable obstacle for the ETF industry."

Still, others argue that differences in names won't prove to be that much of a roadblock. "Not being allowed to call an ETF a money market fund just means that people will have to refer to them as money-market-like ETFs," said Kathleen Moriarty, a partner at Katten Muchin Rosenman.

The New York-based lawyer was involved in the creation of the first ETF, the SPDR Trust (SPY) and consults fund providers as well as government agencies around the world on ETF regulatory issues.

She points out that the SEC adopted Rule 2a-7 to remain consistent with other regulatory moves to keep ETFs and mutual funds as distinct and separate products. "Not being able to call an ETF a mutual fund -- even though both are basically big baskets of stocks -- hasn't hurt the ETF industry at all," Moriarty noted.

Too Early To Tell?

The naming issue and stable value equation hasn't made much of a dent so far in the NAV of the WisdomTree U.S. Current Income Fund. The ETF came out in May, and its portfolio has an effective duration of about 20 days. But its weighted average maturity, which doesn't count dividends, is 14.93 days.

"Those figures make USY seem like a money market fund. But diversity and quality of the securities are other criteria necessary to consider a fund a true money market," Crane said.

Besides commercial paper, the fund can also invest in such high-quality securities as short-term Treasury bills and notes.

In fact, WisdomTree on its Web site says: "Although this fund invests in very short-term, investment grade instruments, the fund is not a ‘money market' fund and it is not the objective of the fund to maintain a constant share price."

State Street Global Advisors has filed to launch what appears to be another ETF that would have duration and credit-quality characteristics of most money market mutual funds. The SPDR S&​P Commercial Paper ETF plans to purchase investment-grade securities with 31 to 91 days in maturity, according to its filing.

"This should be a true money market -- or as close as it gets -- in ETFs," Crane said. "There have been others launched recently, but most of them are really enhanced cash, or ultra-short, bond funds."

But Crane doubts SSgA will call itself a money market fund, either. "Though like the WisdomTree ETF it's very close, in order to call themselves a true money market fund, they've got to adhere to strict SEC regulations in terms of quality, maturity, diversity and maintaining a stable NAV," he said. "I'm not sure those can be matched exactly in an ETF format."

An ETF will need to ask for special exemptive relief to call itself a money market, he added. "The grand bargain of money market funds is, in order to maintain stable value in pricing, you've got to be able to use a special form of accounting," Crane noted.

USY basically holds the same types of securities as a conservative money market mutual fund, agrees Bruce Lavine. "We're not guaranteeing constant-value NAVs. But if you look at the history, it hasn't moved around much at all," said WisdomTree's president.

The ETF's NAV opened at $25 per share. That has gone up on the high end to $25.08. The portfolio's current yield-to-maturity is 2.33%. Its seven-day yield is 2.09%. The average money market mutual fund has a seven-day yield of 2.21%.

"To be a money market fund, you've got to comply with the 2a-7 guidelines, which require a constant NAV at all times," Lavine said.

Creation & Redemption Process

With an ETF, there's no direct transaction between sponsors and the ultimate fund shareholders. Due to this unique creation and redemption process, says Lavine, "We're in new territory, exploring ways to make the accounting similar to a traditional 2a-7 fund, so we can go head-to-head against traditional money market funds."

Money market mutual funds don't actually guarantee a stable NAV, noted Richard Morris, deputy general counsel at WisdomTree. "As short-term instruments, they're valued at amortized costs," he added.

For example, if its underlying investments were worth less than the amortized cost of the entire portfolio, a mutual fund doesn't necessarily have to recognize a lower valuation on a daily basis, Lavine adds. "From an accounting perspective, you don't have to mark-to-market the underlying instrument on a daily basis with money market mutual funds. The NAVs are smoothed," he said.

The value of the securities in a money market fund is just part of the equation. In order to maintain a constant asset value, money market mutual funds also declare dividends, typically credited on a daily basis. That income from short-term investments and payment of dividends helps support a constant NAV.

At some point, the fund pays out those dividends to investors, which decreases the fund's value. That interaction between income streams and paying out dividends is managed to a large degree by transfer agents. Those are companies that are specialists in maintaining records and processing payments to make sure that dividend and income streams mesh to help keep NAVs stable.

Dividends Handled Differently

For an ETF, the income coming into the fund works exactly the same as it does with a money market mutual fund. The process of declaring dividends, however, is quite different. Lavine notes that USY's dividends are declared and paid on a monthly rather than a daily basis.

"Once these sort of accounting issues are resolved, it's very possible that USY would become a 2a-7 fund," he said.

Lavine won't venture how long that could take or how close the industry is to coming up with a solution. But he says even with the naming issue, USY should be able to fill the niche of many income-minded investors.

"There has been an amazing amount of concern lately about what's actually inside a money market mutual fund," Lavine said. Indeed, several large fund companies have had to dip into their reserves to replenish their money market funds in order to stop any losses of principal in the wake of the credit crisis.

"USY remains one of the few money-market-like instruments on the market today that disclose its holdings on a daily basis," added Lavine. "That's not something traditional mutual funds do."