Mike Ronald, an investment professional at Marriott, highlights some unexpected risks associated with money market funds…

Money market funds are a popular investment especially for capital sensitive investors. Under normal conditions they would mimic a bank deposit offering capital stability with attractive interest rates. An investor, though, must be aware of the nature of the securities held in a money market fund and how these securities may behave in unusual circumstances.

Money market funds were created by the collective investment industry to attract clients who were traditionally bank depositors. Until their creation the collective investment industry had only attracted investors comfortable in investing in equity and bond markets. A significant number of investors, though, prefer the capital safety of a bank deposit and this client base had been overlooked by the collective investment industry. In order to expand the offering of the industry, money market funds mimicking bank deposits were created.

Capital price normally stable

Unlike other types of collective investments, a money market fund normally has a stable capital price of R1.00 with all the returns being given to the investor by way of a daily-calculated yield or interest rate. In its simplest form a money market fund could consist of a collection of bank deposits with various terms of maturity. The income accrued each day, less the day’s expenses, is calculated and passed on to the client similar to a daily call rate. A rolling average of these daily yields is calculated and published as the fund’s yield. This published yield, being an average, will tend to smooth out any daily anomalies and prevent the published yield from varying too much. Regulations stipulate the kinds of instruments that such a fund may invest in, the maximum term of each instrument (not greater than a year) and the average term of the fund (no greater than 90 days).

Money market funds have become enormously popular and have attracted a significant amount of flows into the industry, swelling the total market. In order to remain attractive, money market funds have included quite varied instruments. Bonds with a suitable duration are often included in order to increase the yield of the fund. But such instruments come with capital risk and values which can vary on a daily basis. Any capital variance gets added to or subtracted from the day’s net income in arriving at the day’s rate. Hence, a bond originally purchased at a small discount could result in more income than just the interest earned by the fund being earned by the client. The opposite also holds true and any downward move in asset values would reduce the income earned by the client. Because of the short terms of the investments, variation on a daily basis wouldn’t, under normal conditions, cause significant loss of income.

Fund price can decline

Other kinds of investments that could be included in a fund are deposits held with a bank but backed by a defined set of assets, often termed asset-backed deposits. Such deposits do not mimic ordinary bank deposits, which have complete capital stability and interest earned at a predefined rate. These deposits only maintain capital under certain conditions and interest earned from the deposit is not predefined but earned with reference to the returns earned by a predetermined set of investment instruments. Hence the income earned and, under certain circumstances, the capital value of these deposits can fluctuate, sometimes with significant results. If this investment was significant enough, it could lead to a portion or even all of the income in the money market fund being eroded and may even, in some instances, lead to a decline in the price of the fund.

Over time, then, the investments found in some money market funds have become more complex and, with that, more risky. This risk can sometimes lead to capital loss within a fund which is passed on to clients as lower interest earned. Under extreme conditions, the capital loss can be so great that the R1.00 price of the fund has to decrease. For example, during September 2008, an American money market fund had to decrease its price below $1.00 because of its exposure to Lehman Brothers. This resulted in large outflows from the fund and American regulators had to offer temporary insurance to money market investors to restore lost confidence in the product.

It is important to realise that some money market funds, under certain conditions, might not mimic an ordinary bank deposit. Of critical importance to investors is the need to understand the types of investments held in their money market funds and to understand how these investments will behave under extreme market conditions. A money market fund can be a safe way for investors to maintain their capital and earn very attractive interest rates. However, this can only be achieved if the investments within the fund behave in the same way.

We would suggest that investors discuss the nature of the securities used in any money market fund with their financial advisors in order to ascertain that their investments are sound.

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