By design, money market funds are among the most conservative investments imaginable. They only invest in securities of high credit quality and short maturities in order to ensure that investors can withdraw their funds at a moment’s notice and not be exposed to market or credit risks. So, needless to say, significant losses of money market funds during the 2007-2008 crisis came as a huge surprise to investors, regulators, policy makers – and often to managers of these funds themselves.

It turns out that in response to the pressures of the low return environment, money market funds invested in complex and opaque instruments, including asset-backed commercial paper, asset-backed securities, and structured notes. Despite high credit ratings, these holdings had significant exposures to subprime defaults and other financial risks, which was not at all transparent. These complex securities also posed liquidity risks: in the event of a loss of financial market liquidity, if an asset manager were to sell assets to meet customer withdrawals of funds, these securities will suffer additional price declines.

At the present time, finally, the lack of transparency of money market funds and their investment risks are fully acknowledged by all the stakeholders. However, the debate stops short in exposing the risks that money market funds pose to asset managers themselves, mainly focusing on the reputational risk. It has been reported, for example, that in order to mitigate reputational risks to their larger franchises, asset managers have been replenishing money market funds under management and taking other related actions. Earlier this week, it was disclosed that Morgan Stanley bought $23 billion from its money market mutual funds faced with massive withdrawals. Earlier this year, Legg Mason put nearly $520 million into its struggling funds to cover the shortfalls.

Business models of asset managers are typically considered purely fee-based businesses, and hence, high P/E ratios are assigned to these firms by the equity markets. This is, however, not a true depiction of reality. First of all, fees of asset managers depend on their assets under management that, in turn, fluctuate with the performance of financial markets. Therefore, in the language of risk-based based performance introduced in Financial Darwinism, in addition to the fee-based component, economic performance of asset managers contains a systematic risk component.

Recent events have revealed that asset managers’ exposures to systematic risks are even more multifaceted than previously thought. Reputational risk essentially means that asset management firms are exposed to various short options on equity markets, interest rates, credit spreads, and other systematic risks. Additionally, they are exposed to liquidity risks. Business models of asset managers are more complex than they appear. For asset managers themselves, this means that, just like other financial institutions, the decision on whether these risks should be hedged out or whether the firm’s capital should allocated against them should be explicitly made. For investors in asset management firms, these companies’ contingent liabilities and risks (including those posted by money market funds) need to be understood and incorporated into equity analysis and valuation.