Government Business

Money market funds are mutual funds that invest in high quality, short-term money market securities. If an investor places money in one bank deposit account, all of their risk is linked to a single bank. On the other hand, money market funds are required by law to invest in securities issued by several entities (e.g. banks, governments, companies), and many hold securities from dozens of issuers. As a result, an investor in a money market fund has limited exposure to any one issuer, frequently less than two per cent of their total investment.

Investment in a money market fund also provides access to a professional cash management team. The investment manager will employ dedicated portfolio managers and credit analysts who can extensively analyse potential investments. These benefits are provided for a fee which is small when compared with the likely cost of having such resources in-house.

Money market funds are required by law to have their assets held by a depositary. The fund’s custodian will hold the fund’s assets in a separate, ring-fenced account which is identified as belonging to the fund. This provides an additional level of security for investors. Investors in a money market fund are considered shareholders of this investment account, or part owners of the fund.

Comparing money market funds
Whilst all money market funds offer advantages compared to bank deposits, not all money market funds are the same. Money market funds are generally managed to provide capital security, liquidity and competitive money market returns. However, some funds concentrate more on capital security and/or liquidity, whereas others put more emphasis on achieving competitive money market returns.

With no two funds being equal, some simple comparisons can allow an investor to gain an understanding of how risky one fund is with respect to another. Although many money market funds are managed according to conservative guidelines, these funds are not risk free and are not guaranteed. Appreciating the risks associated with a given fund will allow an investor to best identify the fund which meets their needs.

Investment risks that are frequently considered when analysing money market funds include interest rate, credit and liquidity risk.

Interest rate risk
Since money market funds hold fixed income securities, they are impacted by changes in interest rates. The value of these securities generally increases whenever interest rates decline. As the Bank of England has recently been lowering interest rates, money market funds with more sensitivity to interest rate risk have benefited (since the value of the securities which they owned increased). When interest rates will rise, funds with less sensitivity to interest rates will benefit.

Investors can measure the interest rate risk of a money market fund using modified duration, or Weighted Average Maturity (WAM). Both of these statistics are calculated based on the estimated cash flows of the securities, i.e. initial principal invested and interest received during the security’s life. The longer the modified duration or the higher the WAM, the more the fund will react to changes in interest rates. As shown above, the economic environment conditions determine whether or not it is beneficial to take on interest rate risk.

Credit risk
Certain types of money market funds only invest in government securities. Sterling government money market funds can only buy gilts, which benefit from the top rating of the UK (AAA). Investors looking for a slightly higher return can invest in traditional money market funds, which invest in short-term gilts and money market securities issued by corporations. When purchasing short-term sterling securities issued by corporations, investors take on the risk that the company will default, or not pay back the initial principal. In return for taking on this credit risk, investors in these bonds get a higher return than gilts with a similar maturity.

Investors can evaluate the credit risk of a money market fund by looking at the credit ratings of the securities held by the fund. Additionally, credit risk is sometimes approximated by Weighted Average Life (WAL), or the weighted average final maturity of the securities in the fund. A fund with higher credit quality, or lower WAL, should be less susceptible to losses due to issuer defaults. However, as mentioned above, these funds are likely to offer a lower return.

Liquidity risk
During the recent financial crisis, many fixed income securities effectively stopped trading. This presented a problem for investors in these securities, including money market funds, as it was not possible to sell the securities to obtain cash. During this time, investors had to resort to ‘natural liquidity’, or the maturing of their investments. Even in a market with no trading – which is very rare – when a security matures the fund will automatically receive the initial principal invested (barring any defaults as mentioned above). Funds invested in securities that mature will receive these proceeds, and can then pass them along to investors wishing to exit the fund.

Investors can estimate the liquidity of a money market fund by looking at the amount of securities maturing overnight and in one week. Holding securities with very short maturities, such as overnight and one week, will provide natural liquidity to the fund irrespective of the market conditions. However, funds which hold a large amount of securities with very short maturities are likely to offer a lower return in a normal interest rate environment.

Obtaining additional information
In order to obtain more information about money market funds, investors can look at copies of 1) the fund’s prospectus, which is a detailed description of how the fund is set up and makes its investments, 2) a simplified version of this prospectus, as well as 3) the fund’s annual report.

Investment managers also publish monthly factsheets which provide a brief overview of the fund and its performance. The simplified prospectus and factsheets often include many of the statistics to measure investment risk, which are mentioned above.

Additionally, several data providers publish regular information on money market funds, including many of these statistics.  

Some of these services are freely accessible via the internet, whereas others require a subscription. In all cases, investors can contact the investment manager for more information on how the fund is managed.

Before investing, it is key to identify a suitable investment which provides prudent cash management. Money market funds can provide a viable means of obtaining both security and liquidity. However, given the variety of funds available, an investor should carefully assess any fund and consult with financial professionals before investing.

About IMMFA
It is the trade association for providers of triple-A rated money market funds. IMMFA’s main objective is to ensure that members offer a high quality product and service to investors. It aims to achieve this by:

• maintaining a Code of Practice for the industry;
• providing generic information and performance data about the funds;
• lobbying governments and regulatory bodies for appropriate treatment of institutional money market funds;
• supporting the formal recognition of institutional money market funds in the UK, Europe and elsewhere.

For more information
To learn more about IMMFA and its work, please refer to www.immfa.org