Money market funds are typically characterised as short-term portfolios that seek to maximise interest income whilst at the same time preserving the funds’ capital and providing immediate liquidity.
This is accomplished by the fund investing in highly secure and liquid instruments such as wholesale call deposits, bank deposits, negotiable certificate of deposits, treasury bills, jibar linked assets and other interest-bearing securities that are mostly low risk and not available to retail investors.
Such features make money market funds ideal investments to temporarily park money before deploying it elsewhere – as they are generally considered to be safe vehicles with no investment risk. While it is true that money market funds exhibit the lowest risk compared to other asset classes, it is dangerous to accept that such investments are completely risk free.
To unpack this further, we will look at some key risks that help shed some light on this common misconception. In particular, we will look at the following types of risks:
- Liquidity risk
- Credit risk
- Instrument risk
- Inflationary risk
- Reinvestment risk
A major risk that all money market funds face is that of liquidity. This is the risk that the fund is unable to meet its short-term financial demands (due to an extremely large and unforeseen cash outflow, for example) and is forced to sell an asset at a price that is less than its fair value. This may occur if a fund contains illiquid securities that are not easily tradeable in the secondary market, and makes it difficult to convert to cash without suffering a loss in capital and/or income in the process.
Money market funds that have a high market value are better able to absorb chunky cash outflows than smaller funds, and are better equipped to deal with the volume of daily flows into and out of the fund, which may be difficult for smaller money market funds.
Although fund size does help alleviate some of the liquidity risk, investors should still be cautious of the tradability of assets in the money market portfolio. Instruments that are not as marketable may offer a higher return but may need to be sold at a notable loss should there be a run on the fund.
Since money market funds only hold interest bearing debt instruments, the risk to these investments is that the issuers of this debt will default, i.e. they will fail to pay back the borrowed capital and accrued interest amounts. Most issuers of debt have a credit rating which references their ability to pay back their debt. Typically, rating agencies assign these scores but it is not uncommon for asset managers to have their own internal ratings assigned independently as well. This would usually be done by the firm’ credit committee and would generally form part of the company’s risk management and investment processes.
Another way to reduce the credit risk in a money market portfolio is through diversification, whereby investments are spread across a diverse number of borrowers. In this way, should any single issuer default on its loan, then a well-diversified fund may just incur a loss of income and not capital, i.e. the portfolio as a whole would not be impacted too severely.
It stands to reason that borrowers with a low credit score naturally pay a higher yield on their debt. This is to compensate for the higher risk taken by money market funds for lending to them. In light of this, investors should be mindful of funds that produce excessively high returns, and are encouraged to link this return to the underlying risk being taken. This can be accomplished by examining the quality of credit assets and level of diversification in the portfolio - which most money market fund fact sheets allude to.
Closely linked to credit risk is instrument risk, which refers to the risk pertaining to a specific debt instrument. A money market fund may invest in a variety of securities which may have vastly different risk profiles - depending on the seniority and type of asset.
For example, senior secured debt enjoys priority over subordinated debt in the event of default. What this essentially means is that if a company has issued both senior and subordinated debt and files for bankruptcy or faces liquidation, then all the senior debt has to be paid back first, before any subordinated debt can be repaid. Consequently, instruments of a subordinate type offer a much higher return as a reward for the higher risk being taken.
Range accruals are another type of product that offers lucrative returns in a stable economic environment, but when interest rates become volatile and rise or fall more than expected, these returns can quickly and significantly diminish, leaving both the fund and its investors in an unfortunate and precarious position.
Although the returns on these kinds of securities may look very attractive, investors should wary of the risks inherent in these instruments, and the potential loss of return that could arise during adverse and volatile conditions. In addition, it should also be noted that these instruments are generally unlisted products and, as such, have different naming conventions between funds - which may be misleading and cause further confusion for investors.
Consequently, investors are advised to scratch deeper and interrogate the assets in such portfolios as these instruments may not be in the spirit of and may not be suited to most investors of money market funds.
One of the primary reasons that money market funds are not suited to long-term investors is the effect of inflation and the resultant real rate of return. Basically, if the returns from money market funds do not keep up with the rate of inflation, then investors would effectively earn a negative real rate of return. What this means is that the actual purchasing power of the money invested declines. Even though the fund produced a positive return with no capital loss, the income generated would actually buy you less today in real terms than it would have when you first invested it. This is what we mean by a negative real return, and highlights the importance of accounting for inflation when choosing investments.
The effect of inflation, as well as the conservative and low risk nature of money market funds, further emphasises that such funds should be considered as short-term investments only.
Another risk to consider is reinvestment risk, which is the risk of investing future cash flows, i.e. interest received or proceeds from maturing assets, at a lower rate than that which is currently being earned on the security. Remember, money market funds are short term in nature and, as such, have a high volume of short-dated assets that need to be reinvested on an ongoing basis as they mature.
In a rate hiking cycle, reinvestment risk is not so much of a concern, as income received would typically be reinvested at a similar or higher yield, but in a rate cutting cycle the converse is true.
Since falling interest rates naturally reduce the yield on money market funds, whilst simultaneously putting upward pressure on inflation, investors are cautioned to be mindful of where the country is in the interest rate cycle and the effect that this would have on their investments.
Ultimately, investing is a discipline that requires investors to do their homework and research the money market fund they intend to invest in. As suggested above, this should include not only looking at the fund returns but also the risk profile of the fund. In addition, when making important investment decisions, investors are encouraged to consult with their investment advisors, who may be better equipped to help strike a balance between their financial needs and their risk appetite.