Risks and rewards of money market funds
THE ANNOUNCEMENT of the closure of the 25-year-old Absa Money Market Fund may have sparked concern among clients who have their money invested in money market funds.
Absa’s decision should not necessarily be a cause for concern about the validity of a mandate that aims to maximise interest income and preserve capital.
Absa said the main reason for closing the money market fund was that most of their clients believe the capital within the fund, and its associated returns, is guaranteed by Absa Bank. Perpetuating this confusion is the fact that Absa clients were allowed to withdraw money from the fund, treating it like an ATM or a bank account.
A money market fund is not a fixed deposit account or a bank call account, where the underlying capital and returns might be guaranteed; rather, it is a unit trust. A unit trust is regulated as a collective investment scheme. It pools investors’ money, providing an efficient and affordable way to invest in financial markets.
The objective of a money market fund is to offer investors an effective low-risk investment vehicle where they can park their money, by preserving capital while earning interest income higher than one would typically receive in a bank account.
A money market fund is suitable for investors who have a low-risk appetite and an investment horizon of up to one year.
A money market fund primarily invests in high-quality, short-term money market instruments with a maturity of less than 13 months, an average duration of less than 90 days and a weighted average maturity of less than 120 days. These limits ensure that the fund is highly liquid and able to satisfy withdrawals at any time.
The underlying instruments include negotiable certificates of deposit, treasury bills, and credit issued by the government, parastatals, companies and banks.
What are the benefits and potential risks of investing in a money market fund versus a fixed deposit?
◆ Ease of access. There are no lock-in periods, nor are penalty fees applied when withdrawing from a money market fund, as is the case with fixed deposit accounts.
◆ Diversification, which means having one’s risk adequately spread instead of placing all of one’s eggs in one basket. Fixed deposit accounts generally have their investment with a single bank, and although the bank does guarantee one’s deposit, the investor is exposed to a single counterparty risk (risk of the bank defaulting on payment). In contrast, a money market fund adequately diversifies the risk across multiple issuers, preventing the investor from being over-exposed to one bank.
In the world of investing, there is no such thing as a free lunch, and one is always faced with a trade-off between risk and reward. With a money market fund, the risks to be cognisant of are:
◆ Credit risk. If an underlying issuer of a vested instrument goes bankrupt, although this type of debt would constitute senior debt, the investor could bear some losses, as was the case with the collapse of African Bank in 2015 and the Land Bank last year. Although likelihood of this is low, because the types of exposures in a money market fund are mostly in the big four banks, it is not impossible. The mitigating factors are the diversification of issuers and underlying instruments, along with credit analysis that attempts to address this to a certain extent.
◆ Real interest rate risk. Because money market funds invest in shortterm instruments, their returns follow the short-term interest cycle, and whenever official interest rates are lower than inflation, real returns might be negative. In reality, money market rates have tended to outperform inflation and deliver consistent positive real returns.
◆ Liquidity. In an extreme situation where a money market fund receives a request for a large outflow, the fund may be forced to sell its most liquid, high-quality paper first and eventually its long-dated paper, and investors could consequently incur a loss. As mentioned, money market funds invest in shorter-dated, highly liquid instruments, so this tends to be less of a risk for these types of funds. In terms of large liquidations, with proper planning, the execution of asset liquidations and the sound management of client redemptions, the potential negative impact on investors should be alleviated. Considering that money market funds are mainly exposed to highly liquid bank paper, with relatively low average duration, large withdrawals should be easily dealt with.
Money market funds are great investment vehicles for investors who plan on saving their hard-earned money for shorter-term goals. Whatever your short-term goals may be, you will benefit from investing in a money market fund that generates competitive returns relative to shortterm interest rates. The other benefits are capital preservation and the ability to access your savings easily.