William L. Seyfried seyfriedw@winthrop.edu is a professor in the Department of Accounting, Finance and Economics at Winthrop University. James H. Packer is a professor in the Department of Economics and Finance at the University of Central Arkansas.

Abstract

Examined in this article is whether from 1990 to 1996 money market mutual fund managers anticipated and/or reacted to changes in short-term interest rates in terms of adjusting the average maturity of their asset holdings. Using cointegration analysis and Granger-causality, the authors found that money fund managers both anticipate and react to changes in short-term interest rates. This finding has significant implications for those concerned with and affected by interest rate changes.

I. Introduction

The US securities markets, especially the equities market, are commonly characterized as informationally efficient. This important notion of market efficiency is labeled the Efficient Market Hypothesis (EMH). (See Levy, Ch. 12, 1995.) This hypothesis has several important implications for the individual investor. One is that under-priced stocks are difficult to identify. The most often cited evidence that this is true is that professional money managers usually fail to achieve risk-adjusted returns equal to that of index funds. The most obvious implication for investors who, with reason, agree with the EMH is that they should follow a passive investment strategy that focuses on minimization of time, taxes and transaction costs. For those that don’t agree, there is usually some degree of doubt about the extra expenses resulting from an active investment strategy.

The market efficiency concept should also apply to interest-rate-sensitive instruments, such as bonds and money market instruments. If the market for these instruments is informationally efficient, all existing information should already be accounted for in the price and yields of the assets, and market participants should be unable to anticipate any changes in interest rates on a predictable basis. But, contrary to the massive scrutiny afforded the capital markets by investors and academics in an attempt to support/refute the EMH, the one market that has received scant attention is the money market. For the typical individual investor, participation in the money market is epitomized by money market mutual funds (MMMFs). From an origin as recent as the early 70’s, MMMFs now comprise a market of 1200 taxable and nontaxable funds that had assets of more than $1.1 trillion as of early 1998.

One of the central tenets of the EMH is competition. Yield data on MMMFs is readily available for all the world to see and may easily influence investors’ selection of particular funds. MMMF managers can attempt to differentiate their yields by changing risk classes via shifting funds into usually higher yield certificates of deposit (CDs) and, especially, commercial paper (CP) and away from lower yield Treasury securities. This choice is largely guided by each fund’s investment policy. However, the greatest opportunity for money fund managers to differentiate their funds’ returns from others in the same risk class is to forecast short-term interest rates and alter fund maturity in response to the forecast. [Stigum, 1978]

The rationale is that MMMF managers, in the aggregate, can alter the average maturity of MMMF assets to benefit from impending interest rate changes. If rates are expected to increase, then the average maturity will be shortened so that funds’ yields will increase quicker. If rates are headed down, then an increased maturity will slow the yield decline.

Investors should be curious about whether or not the MMMF average maturity index (AMI), and changes in that average maturity provide useful information in terms of impending short-term interest rate changes. Simultaneously, an analysis of the relationship between average maturity and short-term interest rates should provide additional evidence that supports or contradicts the concept of market efficiency as it applies to MMMFs.

This study examines joint questions of the usefulness of aggregate maturity MMMF data and the concept of market efficiency. Similar to Domian (1992), we utilize Granger-causality to determine if a short-term relationship exists between the AMI of the MMMF market (measured in days) and short-term interest rates (proxied by 3-month T-bill rates). In addition, cointegration analysis is used to test for a possible long-term relationship between the same variables. It is not the authors’ intention to determine specifically how MMMF managers forecast the movement of interest rates, just that they may be successful in doing so. Study results would have obvious practical implications from several different aspects.

First, the analysis examines the EMH by focusing on professional money managers. Intuitively, MMMF managers are expected to outperform the market and may exhibit superior timing ability. Investors want to know if professional money managers are indeed successful in anticipating changes in short-term interest rates and are, therefore, worthy of attention. Just what is the future short-term direction of interest rates?

Second, borrowers want the same kind of guidance from the opposite perspective. Should needed loans be negotiated now, or should such an action be postponed in anticipation of declining rates? The third aspect is from the standpoint of policymakers/regulators. A primary component of current interest rates is expected inflation. Scrutiny of a changing AMI may provide evidence of interest rate expectations (including expected inflation) from a policy point of view. And, finally, financial institutions, such as banks, brokerage firms, and even MMMF managers, want to see what others are thinking. These differing perspectives comprise the clientele for the present study.

Section II below delineates previous research. Section III describes the data, hypotheses and methodology. Section IV presents the empirical results and Section V provides a summary and conclusions.

II. Previous Research

The original MMMF kingpin is William E. Donoghue, who created, flourished with, and, later, sold the Money Fund Report to IBC. In his Complete Money Market Guide (with Thomas Tilling, 1981), Donoghue contends his MMMF average maturity is useful in signaling the future direction of short-term interest rates for investors. This book includes unsupported contentions about using changes in the average maturity index to determine what the professionals in the field think interest rates will be in the near future. [1981 119]

Fund managers select, maintain and/or alter their fund’s average maturity based primarily on their expectations of interest-rate changes. Decisions about maturity have an obvious effect on eventual returns. In general, a fund’s average maturity is shortened if rates are expected to rise and lengthened if a decline in rates is anticipated. A small AMI change (+/- 1 to 2 days) indicates that interest rates will be more-or-less stable. The more pronounced the AMI change (especially changes of +/- 3 or more days, and, especially, such movements in the same direction 3 weeks in a row), the more pronounced the change in interest rates. [Donoghue, 1981] These contentions are expressed, with some variation, both in the book and in related articles quoting or expressing Donoghue’s views. [Donoghue 1981; Jasen and Herman 1989; Willis 1988]

Despite the magnitude and widespread use of money funds, little research has been published to date on the subject of fund managers’ ability to forecast changes in short-term interest rates. Ferri and Oberhelman (1981) analyze fund managers’ aggregate ability to shorten maturity before increases in CD rates and lengthen maturity before rate decreases. They examine changes in the overall average maturity index (provided by Donoghue’s newsletter) and subsequent changes in one-month and two-month CD rates during the period November 1975 to July 1980. Their statistical analysis consists primarily of t-tests and classical, one-way analysis of variance.

All average maturity changes examined exhibit the expected signs. Negative AMI changes are followed, on average, by positive CD rate changes. Positive AMI changes tend to be followed, on average, by negative CD rate changes. Most of the results indicating that managers reduce AMI prior to increases in interest rate were statistically significant but, in many cases, significance was not found for increases in AMI being followed by lower interest rates. Ferri and Oberhelman’s overall conclusion is that MMMF managers have a fairly consistent and commendable record of success. [1981 29]

A study by Packer and Pencek (1990), essentially, replicates the Ferri-Oberhelman procedure using a newer, longer sample period, 1982-1989. Their results are generally less consistent and less statistically robust overall than those of the previous study. They find statistically significant results in a few cases for positive changes in 3-month CD rates following negative AMI changes, but not for negative changes in CD rates following positive AMI changes. Questions are also raised concerning some elements of the Ferri and Oberhelman procedure. Their overall conclusion is that the usefulness of changes in AMI appears to be greatly lessened in the 1980’s. [1990 16]

A more recent study by Domian (1992) uses Granger-causality to examine the relationship between fund maturity and interest rates over the period 1982-1990. The author concludes that funds’ average maturity is altered to fit the pattern present in rate changes and not the other way around. Fund managers appear to be reacting to rate changes, rather than being proactive by taking action prior to rate changes. This result implies that changes in maturity by money market funds do not provide useful information.

Donoghue has not provided any empirical evidence to support his contentions other than illustrative examples. The conclusions provided by the Ferri-Oberhelman and Domian studies are clearly contradictory, while the Packer-Pencek findings are more indeterminate, though generally unsupportive of Ferri-Oberhelman. Ferri-Oberhelman conclude changes in the AMI are useful in predicting the future course of interest rates. Packer-Pencek conclude their results are much less consistent and are not statistically robust. Domian’s results indicate MMMF managers are merely reactive and do not anticipate changes in rates.

Are the different results due to the examination of different periods? Ferri-Oberhelman considered the mid- to late-1970s, while the other authors studied the 1980s. In addition, new statistical techniques have been developed since the previous studies were completed – in particular, it is recognized that one should test for cointegration (a long-term relationship) prior to employing Granger-causality (a test for a short-term relationship). The present study attempts to resolve the conflicting results from these earlier studies relative to Donoghue’s contentions about the general usefulness of MMMF average maturity.

III. Data Analysis

In our study we sought to detect both the short- and long-run relationships between AMI and short-term interest rates. To detect a long-run relation, cointegration is employed. Granger-causality is used to examine the short-run relationship in both directions. A finding that short-term interest rates Granger cause AMI would imply that MMMF managers react to changes in interest rates by adjusting their average maturity index. However, if AMI is found to Granger cause short-term interest rates, it would suggest that MMMF managers are able to anticipate changes in interest rates, raising questions about market efficiency.

This analysis of MMMFs uses weekly data from January 1990 to December 1996 for the Average Maturity Index and 3-month Treasury bill rates to determine the forecasting abilities of the fund managers. As pointed out by Domian (1992), a constant portfolio maturity can be maintained if newly purchased securities have about twice the maturity of the overall fund average. Since the AMI during the period studied ranged from 35 to 66 days (See Table 1 below.) securities with two- to four-month maturities would be typical for new MMMF investments. Because the three-month Treasury bill is the most actively traded security in this class, we chose to use its interest rate in this study. The AMI is compiled by IBC Donoghue’s Money Fund Report published in Barron’s. This money fund report creates a weighted average of the maturity of 1200 taxable money market mutual funds. Treasury bill data were downloaded from the Federal Reserve Bank’s FRED database. The database was compiled using secondary market information collected each Friday by the Federal Reserve. Contrary to the multitude of information and data sources available for the capital markets, one dominant information source exists for MMMFs. IBC’s Money Fund Report provides weekly data on MMMFs, including fund asset size, annualized yields and dollar-weighted average maturities of individual MMMFs. IBC also reports a dollar-weighted average maturity for the aggregate MMMF market as a whole, which we have labeled the average maturity index or AMI.