A Deep Pool Is Best

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 and it pools investors’ money together, providing an efficient and affordable way to invest in financial markets. The portfolio managers then use the pooled funds to invest in appropriate instruments, given the mandate – these may include assets such as equities, property, bonds and cash. The investors are then allocated a portion of the unit trust in proportion to the amount of money that they have invested.

The objective of a money market fund is to offer investors an effective low-risk parking vehicle for their money, by preserving capital while also obtaining interest income higher than one would typically receive in a bank account. It is suitable for investors who have a low risk appetite and a short-term investment horizon of up to one year. A money market fund primarily invests in high-quality, short-term money market instruments with a maturity less than 13 months, an average duration less than 90 days and a weighted average maturity less than 120 days. These limits exist to 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 government, parastatals, companies and banks.

What are the benefits and potential risks of investing in a money market fund versus a fixed deposit?

Diversification

This means having one’s risk adequately spread instead of placing all of one’s eggs in an individual 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 has the risk adequately diversified across multiple issuers, preventing 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. Although the Interest-Bearing Money Market category lies at the lowest end of the ASISA category risk spectrum, there are no capital guarantees, even when investing in money market funds. The risks to be cognisant of are in the form of credit, real interest rate and liquidity.

1. Credit Risk

If an underlying issuer of a vested instrument goes bankrupt, although this type of debt would constitute as senior debt, the investor could bear some losses, as seen from the recent collapse of African Bank in 2015 and Land Bank in 2020. While there is a low likelihood of this outcome, given that the types of exposures in a money market fund are mostly in the big four banks, it is not impossible. The mitigating factors are diversification of issuers and underlying instruments, along with credit analysis that attempts to address this to a certain extent.

2. Real Interest Rate Risk

Given that money market funds invest in short-term 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. Inflation spikes over the short term might, however, lead to temporary lower real returns, but should recover as interest rates are adjusted upwards to address the higher inflation. So, although the value of the invested capital may not have decreased, the purchasing power would have. This risk is, however, more prevalent in fixed deposit type instruments where returns are fixed.

3. Liquidity

In an extreme situation where a money market fund receives a request for a large outflow, the fund may be forced to sell their most liquid, high-quality paper first and eventually 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, execution of asset liquidations and 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.