Your money is perfectly safe in a money market fund, right? Wrong! Ian Liddle and Andrew Lapping of Allan Gray discuss the three risks all money market investors are exposed to…

Risk: The possibility that something unpleasant will happen / the possibility of meeting danger or suffering harm or loss (Oxford English Dictionary).

We expect that all readers of this article have come to accept by now that Santa did not squeeze down our chimneys this festive season and that the Easter Bunny will not be knocking on our doors in April. But many of us are still struggling to wean ourselves from a belief in the most fantastical and mythical creature of all: a risk-free investment. So we will say it now: there is no such thing as a risk-free investment.

Understand the risks

The cataclysmic events of 2008 have surprised many of us, but none more than the investor who did not realise the full extent, or even the very existence, of the risk to which he or she was exposed before 'something unpleasant' happened. We want you to entrust your savings to our care with full knowledge of the risks to which you are exposing yourselves. We strive to communicate clearly and effectively to minimise the risk of you suffering a nasty surprise one day.

The purpose of this article is to reinforce this message (which is consistently conveyed in our more formal documentation such as fund fact sheets, unit trust deeds and mandates): Allan Gray does not guarantee any of the funds which it manages in any way whatsoever. Investors in all funds and portfolios under our management are exposed to risk. The nature of this risk will vary dramatically depending on the nature of the investment mandate given to us. Nonetheless, this message applies equally to all types of portfolios which we manage, including the Allan Gray Money Market Fund.

One needs look no further than the 2008 annual investment performance numbers for our suite of unit trusts to see that the Allan Gray Money Market Fund did a good job last year of protecting investors in the Fund from the ravages of falling stock markets — not too surprisingly since its mandate does not allow stock market investments. But that does not mean that the Money Market Fund is a risk-free investment.

On the contrary, investors in the Money Market Fund are exposed to a number of risks which can result in real (and, in extreme situations, even nominal) capital losses. The rest of this article discusses the three major risks to which investors in the Money Market Fund are exposed:

1. Negative real interest rates

2. Credit risk

3. Liquidity risk

Negative real interest rates: the decline of purchasing power

If the rate of inflation exceeds after-tax interest rates, then the spending power of an investor’s capital in the Money Market Fund will decline over time even if he or she re-invests all of the after-tax income distributed from the Fund. Some investors may well say that they prefer to go backwards slowly and predictably rather than very abruptly as happened to equity market investors in 2008. However, most investors probably do not want the purchasing power of their capital to go backwards indefinitely.

Will history repeat itself?

South African savers have been somewhat spoiled since the mid-1990s when real after-tax interest rates for the man-in-the-street turned positive (we have simplified the analysis by using a consistent tax rate of 25 percent). What is the chance of real interest rates being negative for an extended period? It's quite high, if history repeats itself. With the exception of a few short-term blips, real interest rates in South Africa were negative from 1971 to 1995.

Licensed to print money?

Governments around the world are going to be hard-pressed to deliver on their bail-out and stimulus promises and the temptation will certainly be there for politicians to 'print money' and/or engineer negative real interest rates.

To use an extreme example, if you had had the misfortune of investing in a money market fund in Zimbabwe a few years back, you would not have lost a single Zimbabwean dollar, but you would have lost the entire spending power or real value of your investment.

The Allan Gray Money Market Fund provides great protection from falling stock markets, but it cannot provide any protection from the erosion of your real capital should our country’s policymakers choose to administer negative real interest rates (or print truckloads of money in an extreme case). However, other funds in our suite such as the Allan Gray Equity Fund, Balanced Fund and Stable Fund may provide some protection from this risk to the extent that they invest in real assets, such as equities, as opposed to monetary assets.

On page two: The credit- and liquidity risk of investing in a money market fund.

20 money myths, busted! 20 widely-held, yet patently wrong money myths that are keeping you from being wealthy...

SA's best unit trusts An overview of the best and worst performing unit trusts for the quarter ended 31 December 2009...

Money market alternatives Are you retired? Shaun Latter discusses some of the best options for investing your savings...