As of 31^st March, 2011, Morgan Stanley Investment Management had more than 640 investment professionals worldwide who managed and supervised over $275 billion in assets for institutional and intermediary investors from around the globe. With 48 offices in 21 countries MSIM serves a diverse client base of institutional investors, including corporations, endowments, foundations, central banks, government establishments, sovereign wealth funds, health-service organisations, financial institutions, public funds, and union and industry pension plans.

How well has the money market fundindustry responded to the challenges of thepast 12 months?

There is a clear need for those involved with the money market fund (MMF) industry to play an active role in defining and driving positive change. Over the last year, a lot of work has gone into looking at regulatory change here at Morgan Stanley, and through my role as a Director of the industry body for MMFs – the Institutional Money Market Funds Association (IMMFA) – we have been fully involved with the excellent work IMMFA has done in drafting a revised code of practice. The new code reflects the desire of the global industry – outside of the US domestic market – to, for example, ensure minimum liquidity requirements (which require no less than 10% of net assets should mature the next business day and no less than 20% within the next week), that frequent stress testing of portfolios takes place, and that greater transparency is available to clients.

In addition, the European Securities and Markets Authority (formerly CESR) has been active in looking at money market funds and has provided a new definition of short term money market funds (see box). IMMFA worked hard to influence that process which is another positive step.

We at Morgan Stanley would like to see this process go further to create a single, Europe-wide, tight and robust definition that would include funds which are AAA IMMFA style funds only, and thus more clearly distinguish the most risk averse funds.

What do clients look for in a money market fund provider today?

Undoubtedly, there have been changes in the priorities that clients have when looking at fund providers today versus three years ago:

• Credit plays a bigger part in the discussion

  – the size, scope, experience and quality of the credit analysts and the processes they use.

• Transparency has become a key theme

  – how much information does a fund provider make available to clients, how often and how easily?

• Access is a significant demand

  – how willing are credit analysts, portfolio managers and senior management to make themselves available to meet with clients and spend time explaining portfolio composition and market views.

• Liquidity has become a priority

  – it was loss of liquidity within some money market funds rather than a loss of principal that surprised some clients in the crisis.

How important is credit analysis as a differentiator between money market funds and other short-term investment products, and also between providers?

It is fundamental. And I think that credit analysis has always formed a very important part of the way in which the best money market funds are constructed. That is certainly the case at Morgan Stanley. What has changed is the extent to which clients want to understand greater and greater levels of detail about the process and the extent to which they want to have access to the individuals performing those roles.

The number of clients who want to talk to credit analysts has increased dramatically. Four or five years ago, 95% of client interactions would have been through the fund provider’s relationship managers, with the rest being with portfolio managers. That has shifted to a higher proportion wanting access to the portfolio managers and the introduction of clients talking to the credit analysts that I think is genuinely new.

We have very deliberately put client access at the heart of what we do in the Morgan Stanley Global Liquidity business – giving the client direct access to credit analysts and having relationship managers who are willing and able to take them to meetings. This is an unusual approach and it is a differentiator. Access to the source of the credit analysis and openness surrounding the process is key and that is very valuable to clients.

Has credit analysis changed in the new market environment?

The work the credit analysts do has not changed greatly in terms of methodology in firms like Morgan Stanley because there was a rigorous process before and still is today. But clients want to understand more about it. There is also a greater awareness that credit analysis in money market funds is different to the type of credit analysis that is done in a fixed income portfolio. In the latter the analysis will focus on default risk and valuation, while in a money market fund the risk of a downgrade is a major additional consideration. This means that money fund providers need a different skillset and analytical framework, and clients have become much more aware of this. Also, they are much more interested in understanding the quality, depth and breadth of the credit team and much more focused on the organisation sponsoring the fund and the inherent expertise of that organisation to undertake credit analysis.

Inherent expertise?

It has become more important to be able to demonstrate that an ability to execute high quality credit analysis is fundamental to a firm’s business and that the firm has a demonstrable competency in that area. Morgan Stanley is clearly a firm in that category and clients recognise it as such. This is absolutely the core of what we do as an organisation and so we commit very significant resources to it and constantly monitor those activities. This differentiates firms such as Morgan Stanley from providers for whom the analysis of credit risk is not a fundamental driver of their business and is therefore, to some extent, a bolt-on and a very clear differentiator from providers which do not undertake additional credit analysis at all.

How can clients differentiate on this basis?

The first level of reassurance is that the fund should be an IMMFA fund. The second is the ratings – as an IMMFA fund they will be AAA rated by a rating agency, but there are funds which are rated AAA by more than one agency and we would argue that the greater number of agencies the better, since that means the fund must adhere to the strictest criteria of each agency. The third level of reassurance is – does a fund do its own credit analysis? That does not mean simply making sure that everything in the fund is A1/P1 as dictated by the rating agency. It means taking that A1/P1 universe and passing it to the credit analysts for the detailed, comprehensive and continuous analysis I referred to above.

And how can clients evaluate the quality of credit teams?

Let me describe Morgan Stanley’s approach, which we believe to be best in class, with the implication that it makes for a good comparator for any client looking across providers.

We have four dedicated liquidity analysts who focus solely on evaluation of short term money market credits. Two of those team members each have over 25 years of industry experience in money markets and looking at drivers of liquidity in the credit markets. In addition, we have 13 sector analysts who focus their experience within industry verticals along the full credit curve, meaning that they are tasked with establishing and maintaining both liquidity (short term) and credit (long term) views. Having multiple sets of experienced eyes gauging changes in credit conditions and financial performance is critical in protecting investors’ money and earning a reasonable return for a given set of risks.

Our team is organised by sector and geography. That team sets the limits for nominal amounts and duration limits for credits with which they are comfortable. All analysis carried out must be presented to a credit committee consisting of a wider group of portfolio managers and other analysts and other fixed income experts. This provides another level of safety in that there is not a reliance simply on the unexamined view of a single credit analyst. There is peer review. There are challenges to their view and there is ongoing monitoring. Positions are not parked and then left.

Assessing credit risk

Morgan Stanley uses a multi-disciplinary approach to evaluating and monitoring credit risk. Holistically, we view owning a bond as equivalent to being long a treasury security and being short a put option on the firm’s assets (similar to the Merton model approach). We look at the implied asset volatility of the firm as a form of measurement of the distance to default on the liabilities of the firm. The greater the volatility of the underlying assets, the greater the potential for those assets to fall below the value of the firm’s liabilities.

We use equity implied volatility as an input into the forecast of asset volatility, and thus have a measureable quantum of risk from the equity markets that gives us a view on the implied probability of default. When we begin to combine other market-based metrics with fundamental bottoms up research, we are able to triangulate on a view of credit and liquidity that brings a more robust analysis.

In the early spring of 2010, our models took market data from the slope and level of credit default swap curves, equity volatility skew, inversion of the equity volatility curve, and other market measures, and signalled that certain peripheral European banks had significant liquidity risk priced into their market securities. While our fundamental long term view of the credits remained constructive due to these banks’ improving capital ratios, diversity of their revenue and assets, and their strong domestic funding base (among other factors), our shorter term view of liquidity risk remained negative, which was augmented by the signals we were gathering from the market.

We avoided investing in the short term paper of these names as money market spreads rose with growing concerns of the Greek sovereign situation, weak domestic growth figures and upcoming European bank stress tests. Our decision to remove such names from our investible universe helped our funds avoid the risk and volatility associated with subsequent rating downgrades of some of those institutions, as the larger sovereign funding issue became increasingly precarious with trickle down impact to the major financial institutions domiciled there.

What are clients demanding in terms of disclosure and transparency?

We are trying in every way to be as open as we can. Clients want more transparency – they want us to share more information with them, and they want better disclosure – they want that information released to them more quickly and in a more timely fashion.

For example, as CFOs have become more concerned about credit conditions in Europe, treasurers have been asked about aggregate exposure to certain countries. Those using a variety of providers or funds were faced with a manual and time-consuming task of creating that aggregate figure, often from fund data that was days or weeks old. So we, in response to client feedback, changed our weekly portfolio holdings report to show country exposure. And we hope this will encourage other providers to do the same thing, so that treasurers using multiple providers can obtain their aggregate exposures more easily.

We had already moved the portfolio report from being available every fortnight to being available every week on a Tuesday, with the report reflecting the holdings from the preceding Friday, which means as close to zero lag as is reasonably possible with current technology. We also show CUSIP and ISIN numbers where possible, so that treasurers can look up individual securities themselves should they wish to do so.

Furthermore, we’ve added the weighted average life (WAL) measure to our daily reports as well as the more usual monthly factsheets. This provides useful information on the fund’s duration risk because it takes account of the legal final maturity of floating rate notes rather than the weighted average maturity (WAM) which uses the next re-set date instead. With awareness of the value of tracking the WAL growing, we believe it’s a material benefit for clients to have this information available daily.

To take another example, we don’t simply provide a selection of views from our credit analysts, but as I mentioned earlier, we take them to meetings with us so that clients can quiz them directly.

Finally, one of the things that we have been asked to put together by clients very recently is a credit commentary alongside the portfolio commentary and we’re working on this right now.

The message is that Morgan Stanley are continually looking to build the business and to do so in a way which is led by clients. We ask people what they want and we develop it for them. I believe it’s these incremental steps that make a critical difference in the market.