Below, we excerpt from our most recent "Fund Profile, a "Q&A With Federated CEO Chris Donahue.... This month, Money Fund Intelligence interviews Chris Donahue, President & CEO of Federated Investors, Inc. Federated is one of the largest and oldest managers of money market funds, and Donahue has been working in the business virtually since its inception almost four decades ago. We discuss the challenges confronting money funds and the outlook for funds in the coming year.
Q: How long has Federated been involved in running money funds? How long have you been involved? "[Bruce] Bent and [Harry] Brown came to Pittsburgh in '71 or '72 and showed that product to Cliff Brown who was the head of research here, and Cliff Brown pulled open his drawer and said, 'Hey, I got one of those right here.' But our guys couldn't figure out how to make it work at that point, and Brown and Bent did. So when they actually raised a bunch of money, then we, along with a couple others, became in effect the second money market funds in roughly January of '74."
He continues, "This history created a culture that has withstood decades of change and volatility in the marketplace. We understood early on that these products were as much cash management tools as they were investments. We discovered that in the late '70s, when interest rates on money funds dropped bellow passbook rates. Most of our competitors got out of the sales function of competing for a bank trust department because everyone thought the money would just flop over into the bank. By talking to clients, we realized that the yield difference between the fund and passbook rate was not a factor if they were doing cash management systems. So the vast majority of that money stayed and has been with us for three and a half decades."
Q: How did Federated weather the 2007-2008 storm? Donahue tells us, "The first thing that has to happen is that the credit work is king. So, yes, you can do the Government funds and the Treasury funds, but at the end of the day the credit work is king. That is the most important thing in weathering the storm. The intermediary model, for us, has worked very well because you end up with good sales and good uses of the product, because you have to explain exactly what's going on and how it's going to work with the intermediary."
He adds, "But mind you, all of the money that we have, and I think others have, is money seeking daily liquidity at par. It's just that some of that money is more seeking interest than it is seeking daily liquidity at par. We tend to have more of the clients who are really seeking daily liquidity at par. The yield comes along after that."
Q: What's the biggest challenge in managing money funds today vs. historically? Donahue answers, "The biggest challenge is ... avoiding stray bullets. Stray bullets are fired by regulators, legislators, and marketplaces. This has always been the case. When we started with money funds in the '70s, we had a polite disputes with the S.E.C. in the hearing on amortized cost, with the Federal Reserve as to whether or not money funds were required to set reserves ... and state fiduciary concerns about whether putting money into money funds was an improper delegation of authority. These were all forms of stray bullets."
"Today we just have another collection. They all have different names and different labels, but it is the same kind of thing. One of the biggest challenges in money funds today is of course the artificially low yields.... That is the reality of the marketplace. Our structure has enabled us to do that, and yet it's still a challenge because you're not getting compensated for all the work you're doing."
Q: How long can you survive in these low rates? He responds, "We could survive indefinitely with this because of the business model. If you look at an institutional fund on average, if you posit an institutional fund at 20 basis points, then posit third party costs -- State Street, the transfer agent, directors, lawyers, accountants, registration costs, things like that -- call it 3 bps, and then an administrative service fee to Federated of about 7 bps, these added together equal 10. We call those the core expenses. As long as the marketplace has yields above 10 bps we are not subsidizing the fund. The fund is paying its core expenses."
Donahue explains, "Now of course, there is, at 10 bps, nothing left in yield for the shareholder, nothing left in investment advisory fee for Federated, and therefore nothing left to share with an intermediary who has the cost of cash management. So it's not a happy moment. But it's one that could last indefinitely because the fund is functioning at a high quality level and is paying its expenses."
He adds, "We were certainly told by our clients that, even when the interest rates paid on the Government fund were zero during the first quarter of '09, that unlike others, we did not close our funds. The reason was that our clients were overwhelmingly using it as a cash management tool. They understood that it wasn't going to be zero forever ... but they stayed with us right through it and we kept the funds open for that purpose. So it is the strength of the business model and the customers that enable us to answer that question. Although we don't want to, we can sustain this indefinitely."
