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This chapter describes recent U.S. mutual fund developments and examines the market factors that affect the demand for equity, bond, hybrid, and money market funds.

With nearly $16 trillion in assets, the U.S. mutual fund industry remained the largest in the world at year-end 2014. Total net assets increased by $818 billion from the level at year-end 2013, boosted primarily by appreciation in stock and bond prices. Net new cash flow into all types of mutual funds totaled $102 billion in 2014. Investor demand appeared to be driven, in large part, by improving economic conditions in the United States, lower long-term interest rates, and the demographics of the U.S. population. Equity, bond, and hybrid funds each recorded modest net inflows in 2014, while index funds received substantial inflows.

Investor Demand for U.S. Mutual Funds

Investor demand for mutual funds is influenced by a variety of factors, not least of which is funds’ ability to assist investors in achieving their investment objectives. For example, U.S. households rely on equity, bond, and hybrid mutual funds to meet long-term personal financial objectives such as preparing for retirement. U.S. households, as well as businesses and other institutional investors, use money market funds as cash management tools because they provide a high degree of liquidity and competitive short-term yields. Changing demographics and investors’ reactions to U.S. and worldwide economic and financial conditions play important roles in determining how demand for specific types of mutual funds—and for mutual funds in general—evolves.

U.S. Mutual Fund Assets

The majority of U.S. mutual fund assets at year-end 2014 were in long-term funds, with equity funds alone comprising 52 percent of total U.S. mutual fund assets (Figure 2.1). Bond funds are the second-largest category, with 22 percent of assets. Money market funds (17 percent) and hybrid funds (9 percent) held the remainder.

Figure 2.1

Equity Funds Held More Than Half of Total Mutual Fund Assets

Percentage of total net assets, year-end 2014

Figure 2.1

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Investors in U.S. Mutual Funds

Demand for mutual funds is, in part, related to the types of investors who hold mutual fund shares. Retail investors (i.e., households) held the vast majority (89 percent) of the nearly $16 trillion in mutual fund assets (Figure 2.2). The proportion of assets held by retail investors is even higher (95 percent) among mutual fund assets in long-term funds (i.e., equity, bond, or hybrid funds). Retail investors also held substantial assets ($1.7 trillion) in money market funds, but that amounts to a relatively small share (12 percent) of their total mutual fund assets.

In contrast, institutional investors such as nonfinancial businesses, financial institutions, and nonprofit organizations held a relatively small portion of mutual fund assets (Figure 2.2). At year-end 2014, institutions held about 11 percent of mutual fund assets. One of the primary reasons institutions use mutual funds is to help manage cash balances. Sixty-two percent of the $1.7 trillion that institutions held in mutual funds was in money market funds.

Figure 2.2

Institutional and Household Ownership of Mutual Funds

Billions of dollars, year-end 2014

Figure 2.2

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1 Mutual funds held as investments in variable annuities and 529 plans are counted as household holdings of mutual funds.
2 Long-term mutual funds include stock, hybrid, and bond mutual funds.

Developments in Mutual Fund Flows

Overall demand for mutual funds as measured by net new cash flow—new fund sales less redemptions plus net exchanges—slowed in 2014. Lower demand for equity, hybrid, and money market mutual funds was only partly offset by greater demand for bond funds. Overall, mutual funds had a net cash inflow of $102 billion in 2014, down from $175 billion in 2013 (Figure 2.3). In 2014, investors added $96 billion, on net, to long-term funds, and $6 billion, on net, to money market funds. Movements in long-term interest rates, global economic conditions, evolving investment preferences, and ongoing demographic trends appeared to influence mutual fund flows in 2014.

Figure 2.3

Net New Cash Flow to Mutual Funds

Billions of dollars, 2000–2014

Figure 2.3

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* In 2012, investors withdrew less than $500 million from money market funds.
Note: Components may not add to the total because of rounding.

The Global Economy and Financial Markets in 2014

Despite a slow start, the U.S. economy turned in a moderately good performance in 2014. Gross domestic product (GDP) contracted by 2.1 percent in the first quarter as a “polar vortex” of cold weather chilled the economy in the East and Midwest. Growth bounced back dramatically in the next two quarters, with GDP expanding at a 5 percent annual rate in the third quarter, the strongest pace since the third quarter of 2003. For the full year, GDP advanced 2.4 percent, the fastest pace since 2010.

Consumer spending, which comprises roughly 70 percent of GDP, increased by 2.5 percent in 2014. Consumer confidence was buoyed by continued improvement in the housing market, lower unemployment, and declining energy prices. Home prices rose 5 percent in 2014, building on an 11 percent jump in 2013.* Steady improvement in the job market shaved a percentage point from the unemployment rate, which finished the year at 5.6 percent, down from its recession peak of 10.0 percent in 2009. Despite this progress, the labor market continued to face paltry wage gains and difficulty absorbing workers who dropped out of the labor force during the recession.

* Measured by the S&P/Case-Shiller US National Home Price Index.

Meanwhile, sharply falling oil and gasoline prices helped put more money in consumers’ pockets. Inflation worries remained subdued as the Consumer Price Index finished the year up a mere 0.7 percent, with the core rate up only 1.6 percent.

With the economy on firmer footing, the Federal Reserve decided to begin reducing its most recent round of large scale purchases of long-term Treasury and mortgage-backed bonds. While this might have been expected to put upward pressure on long-term interest rates, they fell steadily over the course of 2014. Yields on 10-year Treasury bonds fell from 2.9 percent at the beginning of 2014 to 2.2 percent by year-end. Market participants cited a variety of domestic and global factors as possibly contributing to this trend, including lower expectations for long-term economic growth, the federal funds rate, and inflation.

The recovering U.S. economy spurred a 3 percent increase in after-tax corporate profits in 2014, building on growth of 6 percent in 2013. That, along with few growth opportunities elsewhere in the world, helped drive the total return on the S&P 500 to 14 percent for the year. Stock prices faltered briefly in October amid concerns about a possible “triple dip” recession in Europe, lower oil prices, and the 2014 Ebola epidemic. A second, smaller dip in worldwide stock prices occurred in mid-December over concerns that plunging oil prices might damage oil producing economies, push Europe into deflation, and threaten the U.S. energy renaissance.

U.S. stock and bond markets performed well in 2014, in part, because overseas growth remained disappointing—buttressing demand for U.S. securities. Economic growth in China slowed to 7 percent and the eurozone economy approached a near stall as possible deflation again became a concern. European stock prices* were down 10 percent for the year. In December 2014, the European Central Bank announced its intention to start its own quantitative easing in 2015. As a result of these factors, plus similar easing in Japan, the value of the dollar rose 14 percent relative to both the euro and the yen in 2014. Finally, at the end of 2014, European markets faced renewed concern about Greece, and speculation that it might be forced out of the eurozone, with unknown consequences for the European financial system.

* Measured by the MSCI Europe Index.

Long-Term Mutual Fund Flows

Given continued improvement in the U.S. economy and positive market returns, investors added a modest $96 billion in net new cash flow to equity, bond, and hybrid funds in 2014 (Figure 2.3).

While flows into long-term mutual funds are correlated with market returns, flows tend to be moderate as a percentage of assets even during episodes of market turmoil. Several factors may contribute to this phenomenon. One factor is that households own the vast majority of U.S. long-term mutual fund assets (Figure 2.2) and individual investors generally respond less strongly to market events than do institutional investors. Most notably, households often use mutual funds to save for the long term, such as for college or retirement. Many of these investors make stable contributions through periodic payroll deductions, even during periods of market stress. In addition, many long-term fund shareholders seek the advice of financial advisers, who may provide a steadying influence during market downturns. These factors are amplified by the fact that there are more than 90 million investors in mutual funds. Thus, fund investors are bound to have a wide range of views on market conditions and how best to respond to those conditions to meet their individual goals. As a result, even during months when funds see significant net outflows, some investors continue to make purchases of fund shares.

Equity Mutual Funds

Net inflows to equity funds tend to rise with stock prices and net outflows tend to occur when stock prices fall (Figure 2.4). The return on the MSCI All Country World Total Return Index, a measure of returns (including dividend payments) on global stock markets, was 5 percent in 2014 and 23 percent in 2013. At the same time, equity mutual funds received net inflows totaling $25 billion in 2014, down substantially from $160 billion in 2013. Flows to equity funds varied substantially throughout 2014 (Figure 2.5). Equity funds received net inflows of $59 billion in the first four months of the year. As the year progressed, flows waned and turned negative. For example, equity funds experienced net outflows of $24 billion in December.

Figure 2.4

Net New Cash Flow to Equity Funds Is Related to World Equity Returns

Monthly, 2000–2014

Figure 2.4

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1 Net new cash flow is the percentage of previous month-end equity fund assets, plotted as a six-month moving average.
2 The total return on equities is measured as the year-over-year percent change in the MSCI All Country World Daily Total Return Index.
Sources: Investment Company Institute and Morgan Stanley Capital International

Figure 2.5

Net New Cash Flow to Long-Term Mutual Funds

Billions of dollars, September 2013–December 2014

Figure 2.5

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* In December 2013, investors added $224 million to hybrid funds and withdrew $207 million from equity funds; in May 2014, investors withdrew $229 million from equity funds.
Note: Components may not add to the total because of rounding.

Outflows from equity funds late in the year were likely related, in part, to market volatility. The Chicago Board Options Exchange Volatility Index (VIX), which tracks the volatility of the S&P 500 index, is a widely used measure of market risk. Values greater than 30 typically reflect a high degree of investor fear and values less than 20 are associated with a period of market calm. In 2014, the daily VIX averaged just 14, but peaked at 26 in October and 24 in December. By comparison, during 2013, when equity funds had strong inflows throughout the year, the VIX never closed above 21. Lower stock market volatility during the early part of 2014 likely helped sustain demand for equity mutual funds.

Investors in the United States increasingly have diversified their portfolios toward equity mutual funds that invest significantly or primarily in foreign markets (world equity funds). Over the past 10 years, world equity funds received net inflows of $639 billion, while domestic equity mutual funds experienced net outflows totaling $647 billion over the same period. In 2013, this pattern subsided temporarily and domestic equity funds had their first positive net flow since 2005. In 2014, despite a stronger U.S. dollar, outflows from domestic equity funds resumed: world equity funds received $85 billion of net new cash while domestic equity funds experienced net redemptions of $60 billion.

The strong demand for world equity funds over the past decade also likely reflects the high returns that have been realized in overseas markets. Between 2003 and 2010, international stocks* performed better than domestic stocks, returning an average of 13 percent per year compared with 8 percent for domestic stocks. In 2013 and 2014, however, U.S. stocks significantly outperformed international stocks. In 2014 alone, the total return on the Wilshire 5000 index (float-adjusted), an index of U.S. stock market performance, was 13 percent, while the total return on international stocks was -3 percent. This sharp rise in the market values of U.S. stocks has driven up price-to-earnings ratios on major domestic indexes. For example, at the start of 2013, the price-to-earnings ratio for the S&P 500 was 22. By the end of 2014, this value had risen steadily to 27—roughly equal to the 20-year average. When price-to-earnings ratios are low compared with historical averages, investors may view stocks as undervalued and shift assets into equity funds. This may help explain why the demand for domestic equity funds declined in 2014.

* Measured by the MSCI All Country World ex-U.S. Total Return Index.
Measured by Shiller’s cyclically adjusted price-to-earnings ratio (CAPE).

Asset-Weighted Turnover Rate

The turnover rate—the percentage of a fund’s holdings that have changed over a year—is a measure of a fund’s trading activity. The rate is calculated by dividing the lesser of purchases or sales (excluding those of short-term assets) in a fund’s portfolio by average net assets.

To analyze the turnover rate that shareholders actually experience in their funds, it is important to identify those funds in which shareholders are most heavily invested. Neither a simple average nor a median takes into account where fund assets are concentrated. An asset-weighted average gives more weight to funds with large amounts of assets, and accordingly, indicates the average portfolio turnover actually experienced by fund shareholders. In 2014, the asset-weighted annual turnover rate experienced by equity fund investors was 43 percent, well below the average of the past 35 years.

Investors tend to own equity funds with relatively low turnover rates. In 2014, about half of equity fund assets were in funds with portfolio turnover rates of less than 30 percent. This reflects the propensity for funds with below-average turnover to attract shareholder dollars.

Figure 2.6

Turnover Rate Experienced by Equity Fund Investors


Figure 2.6

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Note: The turnover rate is an asset-weighted average. Data exclude mutual funds available as investment choices in variable annuities.
Sources: Investment Company Institute, Center for Research in Security Prices, and Strategic Insight Simfund

Bond Mutual Funds

Bond fund flows are typically correlated with the performance of bonds (Figure 2.7), which, in turn, is primarily driven by the U.S. interest rate environment. In 2014, as long-term interest rates declined, bond prices, which are inversely related to interest rates, rose. This boosted returns on bonds and bond funds. Bond funds experienced net inflows of $44 billion in 2014, compared with net outflows of $71 billion the prior year.

As 2014 progressed, investors interpreted low inflation, economic headwinds from overseas, and continued slack in labor markets as signals that rates would stay at low levels for the near future. Consequently, compared with the prior year, bond fund investors became less concerned with mitigating capital losses associated with rising long-term interest rates, which resulted in lower demand for bond funds with shorter durations. In particular, short- and ultrashort-term bond funds experienced $21 billion in net inflows in 2014, down from $32 billion in 2013. Meanwhile, long-duration bond funds—such as those whose investment mandates focus on mid- to long-term Treasury bonds, corporate bonds, or mortgage-backed securities—experienced inflows in 2014. Investors put $94 billion, on net, into these fund types in 2014, after redeeming $50 billion on net in 2013. Investors redeemed $44 billion, on net, from high-yield bond funds in 2014. Nearly all of these outflows occurred after June, when the Fed raised concerns about overheating in the high-yield bond market.

Despite several periods of market turmoil, bond funds have experienced inflows through most of the past decade. Bond funds received $1.9 trillion in net inflows and reinvested dividends since 2005 (Figure 2.8). A number of factors have helped sustain this long-term demand for bond funds.

Figure 2.7

Net New Cash Flow to Bond Funds Is Related to Bond Returns

Monthly, 2000–2014

Figure 2.7

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1 Net new cash flow is the percentage of previous month-end bond fund assets, plotted as a three-month moving average. Data exclude flows to high-yield bond funds.
2 The total return on bonds is measured as the year-over-year percent change in the Citigroup Broad Investment Grade Bond Index.
Sources: Investment Company Institute and Citigroup

Figure 2.8

Bond Funds Have Experienced Net Inflows Through Most of the Past Decade

Cumulative flows to bond mutual funds, billions of dollars; monthly, 2005–2014

Figure 2.8

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Note: Bond mutual fund flows include net new cash flow and reinvested dividends. Data exclude mutual funds that invest primarily in other mutual funds.

The aging of the U.S. population has played an important role in boosting inflows to bond funds. Surveys indicate that willingness to take investment risk declines as investors age. In a 2014 survey of households, 25 percent of those aged 35 to 49 indicated that they were willing to take above-average or substantial investment risk (Figure 2.9). In comparison, only 12 percent of those aged 65 and older were willing to take such risks.

Figure 2.9

Willingness to Take Above-Average or Substantial Investment Risk by Age Group

Percentage of U.S. households by age of head of household, mid-2014

Figure 2.9

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Note: Age is based on the age of the sole or co-decisionmaker for household saving and investing. This figure measures willingness to take investment risk for equivalent gain—for example, willingness to take above-average or substantial risk for above-average or substantial gain.

Older investors also tend to have higher account balances because they have had more time to accumulate savings and take advantage of compounding. For example, in 2014, households in which the head was younger than 35 held just 6 percent of households’ mutual fund assets, whereas households headed by 55- to 64-year-olds held 25 percent of households’ mutual fund assets (Figure 2.10). Larger mutual fund holdings of older age groups, combined with the tendency of investors to shift toward fixed-income products as they approach retirement, implies an underlying demand for bond funds by older investors.

Figure 2.10

Mutual Fund Assets by Age Group

Percentage of households’ mutual fund assets, selected years

Figure 2.10

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Note: Age is based on the age of the sole or co-decisionmaker for household saving and investing.

The continued popularity of target date mutual funds also has helped maintain demand for bond funds. Target date mutual funds invest in a changing mix of equities and fixed-income investments. As the fund approaches and passes its target date (which is usually specified in the fund’s name), the fund gradually reallocates assets away from equities toward bonds. Target date mutual funds usually invest through a fund-of-funds approach, meaning they primarily hold and invest in shares of other equity and bond mutual funds. Over the past 10 years, target date mutual funds have garnered inflows of $433 billion. In 2014, target date mutual funds had net inflows of $45 billion and ended the year with assets of $703 billion. The growing investor interest in these funds likely reflects their automatic rebalancing features as well as their inclusion as an investment option in many defined contribution plans. Also, following the adoption of the Pension Protection Act of 2006, many defined contribution plans have selected target date funds as a default option for the investments of newly enrolled plan participants (see chapter 7).

Hybrid Mutual Funds

With the exception of 2008, hybrid funds have seen inflows every year in the past decade. Hybrid funds, also called asset allocation funds or balanced funds, invest in a mix of stocks and bonds. The fund’s prospectus may specify the asset allocation that the fund seeks to maintain, such as investing approximately 60 percent of the fund’s assets in equities and 40 percent in bonds. This approach offers a way to balance the potential capital appreciation of stocks with the income and relative stability of bonds over the long term. The fund’s portfolio may be periodically rebalanced to bring the fund’s asset allocation more in line with prospectus objectives, which could be necessary following capital gains or losses in the stock or bond markets.

Hybrid funds have become an increasingly popular way to help investors achieve a managed, balanced portfolio of stocks and bonds. Over the past eight years, investors have added $436 billion in net new cash and reinvested dividends to these funds (Figure 2.11). In 2014, investors added $27 billion in net new cash flow to hybrid funds.

Figure 2.11

Investors Are Gravitating Toward Hybrid Funds

Cumulative flows to hybrid mutual funds, billions of dollars; monthly, 2007–2014

Figure 2.11

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Note: Hybrid mutual fund flows include net new cash flow and reinvested dividends. Data exclude mutual funds that invest primarily in other mutual funds.

The Development of Alternative Strategies Funds

Equity, hybrid, and bond funds offering “alternative strategies” have attracted considerable inflows in recent years. In many ways, the 2008 crisis evoked a desire among investors to broaden their portfolios and lower the correlation of their investments with the market. In response, fund sponsors created funds that provide an alternative to the long-only strategies of most regulated funds. By creating limited amounts of leverage and investing in a variety of financial securities and instruments, including derivatives, these funds permit investors to gain exposure to strategies and sectors that might be difficult for them to obtain otherwise. Many of these funds also provide investors a means of hedging against declines in various market sectors.

Alternative strategies often involve hedging long positions using options and holding short positions in securities and sectors that appear overvalued. For example, “long/short” strategies seek to provide investors with above-market returns by buying certain securities long (with the expectation that they will increase in value) and selling other securities short (with the expectation that they will decrease in value). Selling short is often employed as part of a “market neutral” strategy, in which the fund attempts to provide positive returns that are independent of market fluctuations. Another strategy, often referred to as a “relative-value” strategy, seeks to take advantage of price differentials between related financial instruments. For example, a fund may track a pair of related securities with historically high correlations and, when the prices of the two securities diverge, buy the lower-valued security and short the other until prices converge again. “Event-driven” strategies also seek lower correlations with equity markets through arbitrage opportunities, specifically those triggered by corporate events (such as mergers, restructurings, liquidations, and new product offerings). Finally, a “macro” strategy seeks to profit from anticipated changes in economic policies that may affect relative currency values, interest rates, and stock index levels.

These strategies have resonated with investors. Assets in alternative strategies mutual funds reached $170 billion at year-end 2014, nearly triple that from five years earlier ($58 billion in 2009). Ninety-nine percent of these assets are invested in funds with equity exposure (i.e., in either hybrid or equity alternative strategies mutual funds). Since the start of 2007, alternative strategies mutual funds garnered $124 billion in net new cash and reinvested dividends (Figure 2.12).

Figure 2.12

Alternative Strategies Mutual Funds Have Grown Rapidly Since the 2008 Financial Crisis

Cumulative flows to alternative strategies mutual funds, billions of dollars; monthly, 2007–2014

Figure 2.12

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Note: Alternative strategies mutual fund flows include net new cash flow and reinvested dividends. Data exclude mutual funds that invest primarily in other mutual funds.

The Growing Popularity of Index Funds

Index funds also remained popular with investors. Of households that owned mutual funds, 31 percent owned at least one equity index mutual fund in 2014. As of year-end 2014, 382 index funds managed total net assets of $2.1 trillion. Demand for index mutual funds remained strong in 2014, with investors adding $148 billion in net new cash flow to these funds (Figure 2.13). Of the new money that flowed to index mutual funds, 41 percent was invested in funds tied to domestic stock indexes, 26 percent went to funds tied to world stock indexes, and another 33 percent was invested in funds tied to bond or hybrid indexes, such as those commonly used to benchmark target date mutual fund performance. Net new cash flow into index domestic equity mutual funds grew from $52 billion in 2013 to $61 billion in 2014, a 17 percent increase.

Figure 2.13

Net New Cash Flow to Index Mutual Funds

Billions of dollars, 2000–2014

Figure 2.13

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Note: Components may not add to the total because of rounding.

Index equity mutual funds accounted for the bulk of index mutual fund assets at year-end 2014. Eighty-two percent of index mutual fund assets were invested in funds that track the S&P 500 or other domestic or international stock indexes (Figure 2.14). Mutual funds indexed to the S&P 500 managed 33 percent of all assets invested in index mutual funds. The share of assets invested in index equity mutual funds relative to all equity mutual funds’ assets moved up to 20 percent in 2014 (Figure 2.15).

Figure 2.14

Funds Indexed to the S&P 500 Held 33 Percent of Index Mutual Fund Assets

Percent, year-end 2014

Figure 2.14

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Figure 2.15

Index Equity Mutual Funds’ Share Continued to Rise

Percentage of equity mutual funds’ total net assets, 2000–2014

Figure 2.15

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Index domestic equity mutual funds and index-based exchange-traded funds (ETFs), which are discussed in detail in chapter 3, have benefited from this trend toward more index-oriented investment products. From 2007 through 2014, index domestic equity mutual funds and ETFs received $1 trillion in net new cash and reinvested dividends (Figure 2.16). Index-based domestic equity ETFs have grown particularly quickly—attracting almost twice the flows of index domestic equity mutual funds since 2007. In contrast, actively managed domestic equity mutual funds experienced a net outflow of $659 billion, including reinvested dividends, from 2007 to 2014.

Figure 2.16

Some of the Outflows from Domestic Equity Mutual Funds Have Gone to ETFs

Cumulative flows to and net share issuance of domestic equity mutual funds and index ETFs, billions of dollars; monthly, 2007–2014

Figure 2.16

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Note: Equity mutual fund flows include net new cash flow and reinvested dividends. Data exclude mutual funds that invest primarily in other mutual funds.

Demand for Money Market Funds

In 2014, money market funds received a modest $6 billion in net inflows. However, similar to the demand for long-term funds, demand for money market funds was not uniform throughout 2014. In particular, outflows from money market funds were concentrated in the first four months of 2014, during which investors redeemed $143 billion, on net (Figure 2.17). Tax payments by corporations in mid-March and individuals in mid-April were likely key drivers behind these redemptions. Outflows abated and money market funds received net inflows of $164 billion over the second half of the year. Most of these flows went to institutional share classes of money market funds.

Figure 2.17

Net New Cash Flow to Money Market Funds

Billions of dollars, September 2013–December 2014

Figure 2.17

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* In November 2013, investors withdrew $414 million from tax-exempt money market funds; in August 2014, investors added $225 million to tax-exempt money market funds.
Note: Components may not add to the total because of rounding.

Institutional money market funds—used by businesses, pension funds, state and local governments, and other large-account investors—had a net inflow of $37 billion in 2014, following a net inflow of $27 billion in 2013 (Figure 2.18). Some of the cash generated by rising corporate profits was likely held in money market funds and bank deposits.

Figure 2.18

Net New Cash Flow to Retail and Institutional Money Market Funds

Billions of dollars, 2000–2014

Figure 2.18

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* In 2012, investors added $1 billion to institutional money market funds and withdrew $1 billion from retail money market funds. On net, investors withdrew less than $500 million from money market funds. Components may not add to the total because of rounding.

Institutions rely more heavily on money market mutual funds to manage their cash today than they did in the early 1990s. For example, in 2008, U.S. nonfinancial businesses held 37 percent of their cash balances in money market funds, up from just 6 percent in 1990 (Figure 2.19). While this portion has declined since the 2007–2008 financial crisis, it remains substantial, measuring 23 percent in 2014. Part of this increased demand reflects the outsourcing of institutions’ cash management activities, which were commonly done in-house, to asset managers. Depending on the size of the cash position, the asset manager may create a separate account for an institutional client with direct ownership of money market instruments or they may invest some of the cash in money market funds.

Figure 2.19

Money Market Funds Managed 23 Percent of U.S. Businesses’ Short-Term Assets in 2014

Percent; year-end, 2000–2014

Figure 2.19

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Note: U.S. nonfinancial businesses’ short-term assets consist of foreign deposits, checkable deposits, time and savings deposits, money market funds, repurchase agreements, and commercial paper.
Sources: Investment Company Institute and Federal Reserve Board

Individual investors tend to withdraw cash from money market funds when the difference between yields on money market funds and interest rates on bank deposits narrows or becomes negative. Because of Federal Reserve monetary policy, short-term interest rates remained near zero in 2014. Yields on money market funds, which track short-term open market instruments such as Treasury bills, also hovered near zero and remained below yields on money market deposit accounts offered by banks (Figure 2.20). Retail money market funds, which principally are sold to individual investors, saw a net outflow of $31 billion in 2014, following a net outflow of $12 billion in 2013 (Figure 2.18).

Figure 2.20

Net New Cash Flow to Taxable Retail Money Market Funds Is Related to Interest Rate Spread

Monthly, 2000–2014

Figure 2.20

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1 Net new cash flow is the percentage of previous month-end taxable retail money market fund assets, plotted as a six-month moving average.
2 The interest rate spread is the difference between the taxable retail money market fund yield and the average interest rate on money market deposit accounts.
Sources: Investment Company Institute, iMoneyNet, and Bank Rate Monitor

Recent Reforms to Money Market Funds

The U.S. Securities and Exchange Commission (SEC) has amended Rule 2a-7, a regulation governing money market funds, several times since 1983, placing greater limits on the maturity and credit quality of the securities that the funds hold, adding diversification requirements, requiring minimum levels of liquidity for the funds, and increasing their disclosure requirements.

In response to the financial crisis, the SEC significantly reformed Rule 2a-7 in 2010. Among other things, these reforms required money market funds to hold a certain amount of liquidity and imposed stricter maturity limits. One outcome of these provisions is that prime funds have become more like government money market funds. To a significant degree, prime funds adjusted to the SEC’s 2010 amendments to Rule 2a-7 by adding to their holdings of Treasury and agency securities. They also boosted their assets in repurchase agreements (repos). A repo can be thought of as a short-term collateralized loan, such as to a bank or other financial intermediary. Repos are collateralized—typically by Treasury and agency securities—to ensure that the loan is repaid. Prime fund holdings of Treasury and agency securities and repos have risen substantially as a share of the fund portfolios, from 12 percent in May 2007 to a peak of 36 percent in November 2012 (Figure 2.21). In December 2014, this share was 31 percent of prime fund assets, still more than double the value prior to the financial crisis and subsequent reforms.

Figure 2.21

Prime Money Market Fund Holdings of Treasury and Agency Securities and Repurchase Agreements

Percentage of prime funds’ total net assets; month-end, 2000–2014

Figure 2.21

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In July 2014, the SEC adopted additional rules for money market funds, further limiting the use of amortized cost for institutional funds that invest in nongovernment securities, and requiring that such funds price their shares to the nearest one-hundredth of a cent. Additionally, under the July 2014 rules, nongovernment money market fund boards can impose liquidity fees and gates (a temporary suspension of redemptions) when a fund’s weekly liquid assets fall below 30 percent of its total assets (the regulatory minimum). The final rules also include additional diversification, disclosure, and stress testing requirements, as well as updated reporting by money market funds. Because the new rules will not be fully implemented until late 2016, it is not yet clear how the SEC’s 2014 rules will affect investor demand for money market funds.

The Federal Reserve’s Overnight Reverse-Repo Facility

In 2013, in an effort to gradually absorb excess liquidity from the financial system, the Federal Reserve began engaging in a new program of fixed-rate, full-allotment, overnight, and term reverse repurchase agreements. The introduction and expansion of the Fed’s reverse-repo facilities over the past two years has greatly increased the central bank’s role as a repo counterparty.

Through these facilities, money market funds (and other market participants) lend money to the Fed overnight or for a specified term. At the end of 2014, the Federal Reserve was the repo counterparty for 52 percent of the $654 billion in repurchase agreements entered into by taxable money market funds. This share has risen from 29 percent at the end of 2013, the year the program began.

The rise, however, reflects a strong seasonal pattern. Money market fund lending to the Fed tends to spike sharply at quarter-ends, in large part because of changes in bank regulations, especially in Europe. Historically, European banks have been a major repo counterparty to money market funds. However, European banks have generally become less willing to borrow from U.S. money market funds due to regulatory pressures, especially at the end of the quarter. Therefore, money market fund lending to the Fed via reverse-repo has offset a quarter-end decline in the share of fund investments in European banks. For example, in December 2013, 31 percent of the repurchase agreements held by taxable money market funds were issued by European banks. By December 2014, that value had fallen to 20 percent.

2014 Fund Reclassification

To reflect changes in the marketplace, ICI has modernized its investment objective (IOB) classifications for open-end mutual funds.

ICI reports data on open-end mutual funds at several levels. At the macro level, the ICI data categories—domestic equity, world equity, taxable bond, municipal bond, hybrid, taxable money market, and tax-exempt money market funds—have remained the same.

The update reclassified the categories at a more detailed level. This means that there is a break in the time series for some of the data in Fact Book.

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