"Cheques aren't money," Andy Warhol famously remarked. And neither are money-market funds. But they can still be a useful investment tool, so long as you pick the best of the bunch and remain aware of their risks and limitations.
However disillusioned you may be with low rates on bank deposits, you cannot avoid holding cash at various stages in your investment career. Cash is useful if you have money waiting to be invested, or if you want to see how the market pans out before deciding on asset allocation. In a bad market, cash is a safe haven from falling prices, and means you can move quickly to take advantage of investment opportunities when they arise.
"You cannot dismiss cash just because it offers an unattractive rate," says wealth adviser Jonathan Fry. "The world is very uncertain and avoiding volatility with part of your portfolio is important." That's especially true if your main objective is preserving wealth. "The loss of wealth often causes significantly more concern than achieving above average investment returns," adds Mr Fry.
Money market funds
Money market funds tend to offer higher returns than bank deposit accounts. However, while the name may imply a fund which just holds cash, this is not the case. These funds invest in more complex and riskier money-market instruments and bonds. This usually produces higher returns than bank deposits but incurs higher risk and can result in negative returns and volatility - a far cry from cash. During the credit crunch crisis, some funds even made substantial losses and were closed down (see ).
Money market funds are less transparent than bank accounts because they can invest in a range of instruments. But you will not know about everything they hold, as they only have to declare their top-10 holdings or exposures, rather than their entire portfolio. "You should get a full breakdown of where the money is lent to, not just the top-10 exposures," says Anna Sofat, founder of wealth advisers Addidi Wealth, who has not used money markets funds for her clients since the problems encountered in 2008.
Though some money market funds offer higher total returns than cash, returns are still fairly low as these funds are also subject to low interest rates, and their short-term returns are not outpacing inflation.
Another downside is that money market funds levy charges while bank accounts tend to be free or have minimal charges. "If you are in near-cash investments the margin is small and the return will be negligible," says Ms Sofat. "If you can get a tracker fund for a charge of around 0.25 per cent you should also be able to get money market funds at a small margin."
Nevertheless, money market funds have much lower charges than the average equity unit trust, which typically has a 1.5 per cent annual management charge. Many money market funds charge 0.5 per cent or higher. Exceptions include Fidelity Moneybuilder Cash and Fidelity Cash, and Jupiter Cash which charge 0.4 per cent.
Cash plus
Despite their detractors - Mr Fry is not a great fan - there are some valid arguments in favour of money market funds. The financial crisis showed the dangers banks face, and how deposit holders could be seriously at risk, although the Financial Services Compensation Scheme will now refund up to £85,000 cash per person in the event of a bank going bust.
If you have more cash than this you should spread it around, and money market funds are an instantly diversified investment as they typically have exposure to around 30 banks.
Diversification helps lower your risk, adds Paul Smith, fund manager of the Premier UK Money Market Fund. A money market fund can hold floating-rate notes as well as deposits to boost returns, but move out of them to avoid risk. It can also hold investments of different maturities and change this accordingly to manage risk - just as bond funds do. "It is a mistake to assume that floating rate notes and bonds are higher risk," says Mr Smith. "They can be lower risk, as it is the bank or institution that is issuing them that is important. For example, at the moment a bond from a good credit is probably safer than a deposit in a Greek bank. During the financial crisis it was hard to trade deposits but you could trade bonds."
He also points out that to get higher rates on a bank deposit you may have to lock up your cash for a year or more. But you have instant access to a money market fund. If your money is invested via a fund platform you can easily move your money in and out of cash funds to other funds, and depending on your platform provider and the charging structure, it may be cheaper to move round funds on the platform than going in and out of funds and bank accounts. While some platforms and pensions offer the option of putting your assets into cash, some don’t, so for short-term safety your best option may be a money market fund.
Money market funds do not make good returns relative to other fund sectors, but they are not meant to - their purpose is to preserve rather than grow your assets. As with other types of fund, it is not fair to tar them all with the same brush. There are currently 30 money-market funds in the Investment Management Association's (IMA) Money Market sector and most did not experience severe problems in the financial crisis. While average sector returns are low, some funds have outperformed this, so even after charges you should get a positive return.
At the height of the financial crisis in 2008, 24 money market funds made positive returns, at a time when the FTSE All-Share plunged more than 30 per cent. During this year the Money Market sector average total return was 2.2 per cent making it the fourth best-performing fund sector out of more than 30. By contrast, absolute return funds, which are always meant to make positive returns, lost 3.6 per cent on average.
Last month the UK fund industry trade body, the Investment Management Association, began consulting on a new definition for money market funds following the introduction of new rules by the Financial Services Authority (FSA). Fund providers have until 1 January 2012 to bring their funds into compliance with the regulations, and from then on the IMA will monitor money market funds to ensure they follow the rules.
These steps show that sector has learned a lot since the problems incurred during the financial crisis. It has made fund managers sit up and take notice of how their funds are invested, and the monitoring should hopefully ensure this continues.
