Are Money Market Funds the Safest Port in a Rough Financial Ocean?
Financial markets can resemble a turbulent ocean, especially so right now! Having a safe harbor, and knowing when to use it, is critical to maintaining financial health. There are many such tools available to you for managing your short term cash. In this post, we will talk about one of the most frequently used: the money market fund.
What are Money Market Funds?
In the purest form, a money market fund is a mutual fund operated by an investment manager. Think Vanguard, Schwab, PIMCO, etc… The goal is to provide high liquidity with low risk. Investment returns are placed on the back burner. Money market funds are regulated by the SEC under the Investment Company Act of 1940. SEC Rule 2a-7 outlines the specific criteria that need to be met to function as a money market fund.
Some of the main characteristics of a money market fund are:
- Assets cannot have a remaining maturity longer than 13 months
- A MMF may invest only in US dollar denominated assets presenting minimal credit risk at purchase
- No more than 5% of total assets can be in illiquid securities
- A minimum of 10% of total assets must be daily liquid
- A minimum of 30% of total assets must be weekly liquid
- Portfolio holdings must be posted monthly on the fund’s website
Because a money market fund is an investment vehicle and not a bank deposit, there is no guarantee on your investment principal. You can lose money!
Mechanics of Money Market Funds
A money market fund is an open-ended investment vehicle. This means that investors pool their funds together to invest in assets on a continuous basis. The fund manager issues redeemable shares that investors can buy and sell daily. The price of the redeemable shares is based on the underlying value of the assets in the fund. This is referred to as the Net Asset Value (NAV).
Money market funds are designed to have a stable NAV. It should hover around $1.00 per share, deviating only slightly in either direction. Fund managers achieve this by collecting income daily and issuing a monthly payout to investors that accrues at a variable daily rate.
It is highly uncommon for a money market fund NAV to drop below $1.00 per share. This is called “breaking the buck” and has only happened a handful of times in history. When it does, it means loss of principal for the holders of the fund. Fund operators can avoid breaking the buck by purchasing stable assets or putting more of their own money into the fund if underlying asset values move negatively.
Variations of Money Market Funds
Investment managers offer a variety of money market funds. Each fund holds different assets that produce varying levels of expected return and risk. The tables below outline the four main types.
How to Evaluate a Money Market Fund
With such a large selection of money market funds & managers, it can be difficult to decide on a fund. For that reason, we are going to discuss the risks when considering a money market fund as part of your cash management policy. This is not an exhaustive list, but it highlights the primary considerations:
1. Credit Risk
You Can Lose Money
As noted earlier, a money market fund is an investment vehicle that strives to maintain a NAV of $1.00, but does not guarantee that. This means that you can lose money.
The assets inside each fund are purchased because of their perceived stability in price. While each individual asset price can move, on aggregate, the NAV of the fund should remain stable at $1. During extreme financial distress the underlying assets in a money market fund can gyrate significantly. This happened most recently during the 2008 financial crisis and many money market funds moved below a NAV of $1.00, or broke the buck. If you were in the unfortunate position of needing to redeem your funds during this period you would have lost money.
A secondary concern in the credit risk area is that the manager of the money market fund can fail. In the 2008 financial crisis there were a handful of investment managers that went out of business. Even though the assets inside of their money market fund were sound, their business failure put your invested capital at risk.
2. Liquidity Risk
You Might Not Get Your Funds When Needed
Most investors in money market funds assume they can redeem and get their cash back at any time. Generally, this is true. The caveat is that some money market funds can have liquidity provisions or limitations on redemption schedules.
In times of market turmoil, investors theoretically could attempt to redeem all their shares at the same time causing a run on the fund. This is just like a run on the bank. This recently happened during March 2020 to a Goldman Sachs fund, requiring them to inject over $1 billion into it in order to maintain it’s NAV and prevent investor losses.
To avoid replays of extreme events many money market funds now include certain provisions to mitigate future disruptions. Two of the most common are
- Redemption Schedule – time restrictions for fund withdrawals. A way to slow the flood of cash leaving the fund in times of uncertainty.
- Redemption Gate – a fee that an investor is charged to disincentivize them from redeeming their money.
Most funds do not have these provisions, but you should always check to make sure you know what you are buying.
3. Interest Rate Risk
You Can’t Replace the Yield
A money market fund rate is not locked in. Rates change daily as the yield on the assets inside of the fund adjust. This is great when rates are rising but if they are trending lower it becomes a problem.
Recently, yields on US Treasuries have been trending toward 0%. This has had an impact on government money market funds because their yields have had to move lower as well. If you invested in one of these funds a year ago you had a return north of 1%. Now these funds are yielding closer to 0.25% and could go even lower!
If you wanted to replicate the previously held higher yield, you could not do it any longer with US Treasuries. You would be forced to invest in what are perceived as higher risk assets. The inability to replicate the safety and yield profile you had previously, but can no longer attain, is interest rate risk.
4. Inflation Risk
You Lose Buying Power
The higher costs of goods and services plus the devaluation of the US dollar’s buying power creates inflation risk.
This means that if you have your assets in a money market fund returning 1%, and inflation is hovering above 2%, you are losing money net of inflation. Due to the nature of the assets inside of a money market fund, you are trading stability and safety for the purchasing power of your dollars. For this reason, some investors will invest in higher-yielding assets like investment grade and high yield corporate bonds instead.
The Manager Eats the Return
The final risk you need to consider when looking at a money market fund is the fees associated with it. The two primary fees are the management fee and 12b-1 fee.
Running an investment fund is a business and, as in all businesses, there are costs. The management fee is what covers these expenses. Transaction costs, portfolio manager salaries, marketing, legal, audits, customer service and more fall in this category.
A 12b-1 fee is to cover the marketing and promotional costs the fund manager incurs to gather assets. This cost is passed on to the investors of the fund.
Fees are a drag on fund performance, so always look to see what you are being charged. The best places to see what a fund is charging is in the prospectus.
Money Market Fund Alternatives
The general point of a money market fund is to keep cash safe and retain quick access to funds, but it’s not the only type of investment you can use for this. Here are a few alternative instruments that can serve a similar purpose.
1. Cash – Checking & Saving Accounts
Yes, keeping a large balance of cash on hand is a simple solution to the safety and liquidity conundrum. However this could mean that you earn no return and lose buying power due to inflation. These accounts are typically best for holding only as much cash as is needed for immediate operations.
2. Bank Certificate of Deposit
A bank certificate of deposit is a deposit loan to a banking institution for a certain period. The bank generally gives an interest rate above what you can get with government bonds in exchange for locking the money up for a certain amount of time.
The downside is that if you need your funds early, you will likely pay an early termination penalty. These penalties can cost you all or most of the interest you have earned. Always make sure you understand what the early termination penalties are when buying a CD.
3. US Government Treasuries
Most bank savings products derive their interest rate from US Treasuries. If you wanted to cut out the bank and the potential penalties, you can buy US government treasuries directly. US Treasuries are considered one of, if not the safest assets in the world because they are backed by the full faith and credit of the US government. They provide next day liquidity for your funds and cost little to buy or sell.
4) Individual Bond Issuers
Many government entities, municipalities, and corporations issue bonds. These tend to provide a higher yield than US Treasuries. The increase in yield is because these bonds have risk and the two primary risks are below:
- Credit Risk – You can mitigate this risk by only investing in issuers with the highest creditworthiness and projected future ability to maintain their payment obligations.
- Mark to Market Risk – because these individual issuer bonds trade in the open market, prices can fluctuate. You face price risk if you need to sell before maturity.
In general, we believe, for corporate cash management purposes holding these bonds to maturity is the best course of action.
Managing your corporate cash effectively requires maintaining a fine balance. Your primary goal should be to have your cash safe and liquid. The secondary goal is to earn a reasonable rate of return without unnecessary risk. There are many tools at your disposal and depending on your cash and investment policy a money market fund may be appropriate.
At InterPrime, we always recommend a periodic review of your corporate cash and investment policy. The decisions you made quarters ago may no longer be helping you achieve the goals you set out to accomplish. The financial markets and economy are always shifting so it’s important to be proactive. We’re here to help. Get in touch if you would like a free and unbiased review of your current cash management strategy.