and $1.005. Because funds can pay out $1.00 on
shares that may actually be worth as little as
$0.995, the remaining participants in the fund
absorb the difference. This is referred to as dilution;
redeeming shares at a price above their actual mar-
ket value is diluting the value of the fund’s hold-
ings. This situation could be significantly worse for
stable NAV GIPs that do not employ frequent
marking-to-market because the pool’s true value
can drop well below $0.995 without it being recog-
nized. In analyzing the pool’s participant base,
Standard & Poor’s examines the expected redemp-
tion characteristics. It then models hypothetical
interest-rate movements in conjunction with reason-
ably severe levels of redemptions in order to judge
the potential dilution a fund may experience.
Standard & Poor’s expects that a fund’s investments
should be tailored to its potential cash flow needs.
For pools with a potentially volatile participant
base, a more conservative approach must be taken
with regard to WAM and liquidity.
Shareholder characteristics
A money market fund’s market price exposure is
also affected by the flow of money into and out of
the fund. Unexpected redemptions have a direct
influence on a fund’s NAV. Therefore, Standard &
Poor’s reviews the characteristics of each fund’s
shareholder/participant base to determine the
potential impact of share redemptions on market
price exposure. This review of shareholder con-
stituency encompasses consideration of the number,
average holding size, type of investor, historical
asset volatility, and the relationship management
has with the participant. The proportion of volun-
tary versus involuntary investors and the past histo-
ry of redemptions are also examined. Pools with
histories of volatile subscription and redemption
patterns are expected to have shorter weighted
average portfolio maturities.
Portfolio valuation
A Standard & Poor’s stable NAV pool or money
market fund rating directly addresses the ability of
a fund to maintain a NAV that does not deviate by
more than one-half of 1%. For a fund to effectively
stay within this narrow range, accurate pricing of
its securities is essential. Most stable NAV pool or
money market fund instruments are highly liquid
and easy to price. However, some complex, struc-
tured, and derivative securities present pricing diffi-
culties. Complex and derivative securities often lack
efficient, liquid markets. Trading in these securities
can be infrequent, creating varying price quotes
among dealers and wide bid/ask spreads.
The prices of these types of securities may be
determined in a variety of ways, including dealer
quotes, matrix pricing formulas, spreads to bench-
mark securities, pricing services, or even by the
fund advisers themselves. All of these methods have
drawbacks. Dealer quotes on thinly (infrequently)
traded securities often represent indicative pricing
levels and rarely constitutes an actual bid to pur-
chase the security. Matrix prices, pricing service
quotes, and spread calculations are not based on
actual trades, and do not represent a price at which
anyone actually offered to purchase the security.
These methods calculate a hypothetical price that is
not verifiable. Pricing by fund managers often
occurs when the manager either disagrees with the
other pricing methods or holds securities so unique
that other pricing methods are inadequate. Clearly,
even if the fund manager can determine fair value
prices based on in-depth analytics, it is far from
certain that any buyers are willing to purchase the
securities at or near those prices.
Before purchasing complex, derivative, or other-
wise illiquid securities, portfolio managers should
carefully examine the pricing issue. It is necessary
to evaluate the number of available pricing sources,
with an eye toward identifying material discrepan-
cies. Portfolio managers should also be aware of
pricing methodology, and should compare the
results to recent trading activity. It is inadvisable for
a fund’s manager to solely accept the calculations of
a security’s issuer or dealer in determining the value
of an investment. This information may be either
highly biased or based on inaccurate assumptions,
or both. Portfolio managers should not only be able
to determine their own fair value for securities that
are difficult to price, but need also to consider the
marketplace for each security and the potential
volatility that can be caused by inefficient market
pricing. If a fund adviser lacks the ability to assess
the potential market behavior of a security with a
high degree of comfort, the security should not be
purchased for that money market fund.
Net asset value (NAV) monitoring
Should a fund experience a situation where stability
of its $1.00 NAV is in jeopardy, there are several
actions the fund may take. These include withhold-
ing dividends, selling securities to realize gains or
losses, valuing the shares at the market rather than
at amortized cost, or waiting out the situation to
determine if the problem is only temporary. In the
rating process, Standard & Poor’s reviews the for-
mal and informal policies and procedures the fund
has in place to monitor and correct such situations.Management
The rating process includes a meeting between the
fund’s officials and fund analysts from Standard &
Poor’s. Standard & Poor’s evaluates the effective-
ness of fund management in implementing ahttp://www.standardandpoors.com 317Government Investment Pool