Alastair Sewell explains the importance of recognising and reconciling the role of responsible investment in money market funds.
Read this article to understand:
- The key short-term risks MMFs are exposed to and how these can be mitigated
- Why investors should consider the long-term risks MMFs are potentially exposed to
- The importance of effective engagement with issuers
Money market funds (MMFs) are short-term investment vehicles. Investors in MMFs may have short investment horizons; MMFs will only invest in short-term securities.
On the other hand, the environmental, social and governance (ESG) risks considered by responsible investment processes are typically longer term.
How then to reconcile the two considerations? First, ESG risks, like all risk events, can materialise quickly, even if overall they tend to emerge over longer horizons. ESG risks therefore matter directly to MMFs. Second, MMFs provide funding to issuers over long periods by rolling exposures. This means MMFs have exposure to the longer-term ESG risks affecting issuers.
As such, MMFs have an important role as long-term investment stewards. As we have argued before, it is a misconception to suggest short-term investors do not have influence, especially when engaging in tandem with portfolio managers of longer-dated strategies.1
Short-term risks
ESG risks tend to emerge over longer time periods. However, it is possible for ESG risks to flare up suddenly, be it an environmental disaster, a governance failing or a sudden adverse social development. This means ESG risks can suddenly become highly relevant to MMFs.
MMFs are highly attuned to short-term risk. As the securities they hold are short dated, they benefit from being able to re-position portfolios quickly, without needing to sell. Although, of course, they can sell positions if they need to do so.
An example comes from the history books, largely pre-dating the modern ESG movement. The case involved BP; the event was the Deepwater Horizon oil spill in April 2010. This was a major environmental disaster in the Gulf of Mexico, resulting from an explosion on an oil well. At the time, BP, owner and operator of the well, had commercial paper outstanding and was sufficiently highly rated to be eligible for MMFs (Fitch: AA+/F1+).2
MMFs with exposure reacted promptly, concerned by the event itself and potential financial repercussions for BP in terms of fines and reparation costs. Most MMFs exited their exposure either through outright sales or allowing existing exposures to mature naturally. In most cases, MMFs exited their positions before the financial repercussions of the event became clear. They were essentially reacting both to potential repercussions and immediate investor sensitivity. While presented, at the time, in largely financial terms, there was also clear concern over “headline risk” and broader investor concerns reputationally over any association with BP. An antecedent then to the modern ESG movement, which would have articulated these developments through an overtly environmental lens.
Poor governance standards can lead to adverse events developing in the short-term
More broadly, most MMFs will emphasise governance in their responsible investment processes. This is because governance risks tend to be the most relevant ESG risks to the financial institutions in which MMFs invest. Poor governance standards can lead to adverse events developing in the short term. Frauds are a case in point – they are a result of weak governance, typically over a prolonged period (the “bezzle” in economist Hyman Minsky’s words), which can blow-up suddenly with near-instantaneous effects on valuations. Investors assume the emergence of one fraud event may be followed by others and will almost certainly be followed by potentially significant fines. This is an ESG risk crystallising into potentially material financial consequences. For MMFs, given their focus on capital preservation, it is incumbent on them to avoid the potential adverse mark-to-market effects emerging from a fraud (or similar) event.
The bottom line: ESG risks matter to MMFs in the short term.
Factoring environmental and climate data into MMFs
As more information becomes available on the climate impact of lending activities, we expect environmental considerations to become increasingly relevant in our assessment of the banks in which we invest.
Long-term stewardship
Focussing only on short-term risks misses a key point: the longevity of MMF exposure to certain issuers. While MMFs can only buy short-term securities, they will typically roll maturities, meaning there can be continuous ongoing exposure to an issuer. Specifically, short-term MMFs can only buy securities with a maximum maturity of 397 days and have additional limits on portfolio average maturity. For further information on the rules governing MMFs, see An introduction to money market funds: The role of MMFs for cash management.3
Using our liquidity funds as an example, we can track continuous exposure to a select group of issuers over a long period. High credit quality names like BNP Paribas and Nordea Bank have been mainstays in our portfolios on a continuous basis since at least 2014.4 A cursory examination of our year-end holdings prior to 2014 shows these issuers have been held in our liquidity funds since inception.
Figure 1: Issuer continuity
Source: Aviva Investors Sterling Liquidity Fund. Data as of May 2023
This means MMFs are an important ongoing source of funding to issuers. Add to this the fact assets under management in MMFs are significant (our sterling fund’s assets were around £19 billion as of mid-April 2023), the choices we and other MMFs make are meaningful for the short-term funding profiles of many issuers on an ongoing basis. Total MMF assets in Europe were €1.6 trillion at the end of 2022, according to EFAMA data.
The choices MMFs make in their issuer selections play an important role in directing funding
The investment decisions made by MMFs matter over the long term. The choices MMFs make in their issuer selections play an important role in directing funding. Hence, the responsible investment policies and practices of MMFs make a tangible difference over the long term. By working with portfolio managers of our other fixed-income funds, we can bolster the effectiveness of our engagement. Our 2022 Responsible Investment Review presents examples of our engagements, including with major banks on climate change.5
As long-term stewards, MMFs should use their influence to engage with issuers. While MMFs, as debt investors, cannot vote on company actions, they can still have material influence. Engagement is a core part of our responsible investment framework, including for MMFs. This takes many forms, from commenting on security documentation (notably advocating for high standards in short-term ESG-labelled instruments), to demanding E, S or G enhancements, or promoting our wider stewardship priorities. We would argue the engagement pillar of a MMF’s responsible investment policy is just as, if not more important, than the exclusions or other ESG activities covered. Long-term engagement can be a more meaningful driver of change than divestment.
Our 2023 stewardship priorities
People
Tackling the cost of living crisis
Climate
Transitioning to a low-carbon economy
Earth
Reversing nature loss
Every January, we send a letter to the chairs of companies we invest in (and some we don’t, but still want to influence) to set out our stewardship priorities for the year. See Our annual letter to company chairpersons to read our 2023 letter.6
Last, but not least
In our insight Reframe and reclaim: How to win the ESG argument, we argued there are certain things ESG can do:7
- Enrich the investment process
- Encourage longer-term investment thinking
- Help drive positive change in issuers
- Help clients align investments with their sustainability preferences
Looking beyond the short-dated exposures owned by MMFs on any given day and recognising the fact MMFs may have ongoing, long-term exposure to an issuer makes these considerations as relevant to MMFs as they are to any other fund. Investors need to reconcile the fact the short-term investments in their funds roll up to have a meaningful difference over a long period. The responsible investment policies of MMFs matter. Over the long-term, it’s the engagement actions that will matter most.
