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Cash on tap

Created:
28 May 2008
Written by:
Moira O'Neill

In the first few months of the year, when markets were volatile, many investors retreated to cash. But cashing in stock market investments and putting your money in the bank is not always convenient or the best option. This is where money market funds come into their own.

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Money market funds invest in high-quality, short-term securities that present minimal credit risk. These funds also pay a return to investors that generally reflects short-term interest rates.

Mick Gilligan, director of fund research at Killik & Co, says: "Most people view them as an alternative to having money in the bank. You should expect a slightly higher rate of interest than a bank account. In theory, you're taking on a fraction more risk to get a fraction more return."

Investors use money market funds for a variety of reasons. Like other mutual funds, money market fund shares can be bought or sold at any time and this liquidity means they can help manage your portfolio. You can have an expected sum of cash at the very moment that you need it. In contrast, to get top rates in bank and building society accounts you often have to sign up to a notice period for withdrawing your money.

Money market funds can be useful if you are looking to store money for emergencies or save for a short-term goal. Some investors also use money market funds as a "parking place" for cash between investments - for example, if you're not quite ready to make an investment.

Stock brokers use money market funds to provide cash management services to their clients.

Mr Gilligan explains: "If you have liquidity issues they can be useful. If you are waiting to invest you can sell a money market fund and buy stock within the same day."

They are also used by investors who hold several mutual funds with a single fund manager and want to transfer assets from one fund to another. If the investor wants to sell a fund before deciding on another fund to purchase, a money market fund offered by the same fund company can be a good place to park the proceeds of the fund sale. At a later date, the investor may exchange the money market fund holdings for shares of other funds in the fund family.

Other times when you might use a money market fund include when you sell your home - you could put the proceeds into a money market fund while you are waiting to buy another property. Also, many investors nearing retirement switch some or all of their pension investments into cash to protect them in the years immediately before their retirement or during times of stock market turmoil.

However, although low-risk, money market funds are not risk-free. Standard Life and Threadneedle recently reported losses in their money market funds and had to restructure their funds in the wake of the credit crunch. At the start of May, the £450m Threadneedle UK Money Securities fund, billed as an ultra-safe alternative to cash, had lost millions of investors' money in the credit crunch. It was down almost 4 per cent over the year to 30 April. Standard Life took a £37m hit after bailing out one of its money market funds and shifting it on to its own balance sheet.

There are several risks attached to money market funds.

First, a money market fund is technically a security. The fund managers attempt to keep the unit or share price constant. However, there is no guarantee. If the unit or share price goes down, you can lose some or all of your investment. Investor losses in money market funds have been rare but, as we saw with the Threadneedle fund, they are possible. In return for this risk, you should earn a greater return on your cash than you'd expect from a savings account.

Second, money market fund rates are variable - the rates can go up or down. In other words, you don't know how much you’ll earn on your investment next month.

Third, there is the risk that inflation can eat away at your returns. Because money market funds are considered to be safer than other investments such as equities, long-term average returns on money market funds tends to be less than long-term average returns on riskier investments.

FUND OPTIONS

There are 24 money market funds available to small investors in the Investment Management Association's Money Market sector, and every one except Threadneedle gave a positive return of between 2.7 and 5.6 per cent over the past year.

Money market funds invest in a variety of financial instruments that offer a cash-like return with little risk. Typical investments include:

• Time deposits: fixed short-term loans to a bank or building society

• Commercial paper: unsecured loan notes with maturities of less than 270 days issued by banks.

• Asset-backed commercial paper: short-term loan notes with maturities typically between 90 and 180 days issued by banks. The notes are backed by physical assets, and are generally used for short-term financing needs.

• Floating rate notes: longer-term variable rate loans issued by banks.

Some fund managers try to boost returns by investing in derivatives linked to these underlying investments.

However, money market funds can also hold much more complex investments, so tread carefully.

Mr Gilligan says: "We would not be comfortable having client money in most of the money market funds. They're not as straightforward as you think. The one I have in front of me has 165 holdings, most of which wouldn't be straightforward to most people. For example, Blue Stone Securities is a mortgage backed security. Lots of money market funds hold things like this."

A good way to distinguish between funds, according to Mr Gilligan, is to see if it has an independent credit rating. For example, the JP Morgan Sterling Liquidity fund has an 'AAA' rating from S&P. "We would consider putting clients' money into this," he says.

JP Morgan Sterling Liquidity is a Luxembourg domiciled SICAV (a type of European investment fund) that aims to offer a high level of security coupled with instant access and a competitive yield. Its investment strategy continues to focus on the debt obligations of governments, international organisations and corporations or financial institutions of high credit standing. It invests in a range of investments including:

• Government, agency and sovereign debt

• Repurchase agreements (a form of short-term borrowing for dealers in government securities)

• Time deposits

• Commercial paper

• Asset-backed securities

• Mortgage-backed securities

• Investment grade corporate bonds.

Note, though, that this fund has a minimum investment of 50,000 euros. For further information, visit www.jpmgloballiquidity.com or tel: 020 7742 6059

If you are a fan of low-cost exchange-traded funds (ETFs), you'll be pleased to learn that Deutsche Bank has launched two money market ETFs - one sterling, one dollar. These are the first money market ETFs to be listed on the London Stock Exchange.

The Deutsche Bank x-trackers Sterling Money Market ETF and the Deutsche Bank x-trackers US Dollar Money Market ETF reflect the Sterling Overnight Index Average rate and the Fed funds effective rate, representing respectively the British and US short-term money market reference interest rates. At launch in April, Michele Faissola, head of global rates for Deutsche Bank, said: "The structure of our money market ETFs is extremely safe. This has been clearly demonstrated during the last few months of market crisis when they have diverged only slightly to the underlying indices, and only as a result of the 0.15 per cent all-in fees."

For further information visit www.dbxtrackers.com or tel: 0207 547 1747

ALTERNATIVE TO MONEY MARKET FUNDS

Guaranteed and protected funds can be a good alternative to money market funds, if you are nervous about stock markets. For example, Close Investments has a 100 per cent protected fund known as the Close Escalator 100 Fund that is akin to a cash fund. The Close UK Escalator 100 Fund aims to provide investors with an exposure to some of the rise in the FTSE 100 index, while at the same time protecting investors' capital (net of the initial charge) against falls.

The fund managers believe the UK 100 fund is an attractive alternative to money market funds and savings accounts and compares favourably against both.

Close Escalator 100 guarantees that the cash-in value will never be below your original investment. Unlike the structured products flogged by many banks and building societies, which tie you in for five or six years, it has daily dealing and you can cash in at any time.

The Close fund locks in profits or gains every three months. It works this way: say you put £100 in and three months later the market was down 20 per cent on your start date, you would still have £100. If you had been in a market tracker, you'd have £80. But if the market was up 20 per cent then, you would get some but not all of the upside.

For further information visit www.closeinvestments.co.uk or tel: 0800 269 824

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