Money market funds are generally managed with the aim of preserving capital, providing liquidity and offering competitive money market returns.
However not all funds are the same. It is important to understand the objective of various funds and find one that is aligned to your requirements.
Some funds concentrate more on capital security and/or liquidity, whereas perhaps others may 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 money market funds may be managed according to conservative guidelines, they 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.
The risks which are most commonly considered when analysing money market funds are: interest rate, credit and liquidity risk.
Interest Rate Risk
As 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.
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 influences whether or not it is beneficial to take on interest rate risk.
Certain types of money market funds, called Treasury funds, only invest in government securities or in reverse repo with government collateral. For example, sterling government money market funds can only buy gilts. Investors looking for a slightly higher return can invest in traditional, or Prime money market funds, which invest in short-term gilts and money market securities issued by corporations and banks. 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 this paper 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 the weighted average final maturity, or Weighted Average Life (WAL) 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.
During the financial crisis of 2007/2008 and subsequent years, there have been times when some 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 in order to generate cash.
Even in a market with no trading - which is very rare - when a security matures the fund will receive the par value of the security - barring any defaults. Funds can then pass them along to any investors wishing to redeem some or all of their investment in 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 very short maturities securities 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) the Key Investor Information Documents (KIIDS), 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 KIIDS and factsheets often include many of the statistics to measure investment risk which are mentioned above.
Some managers provide interim information more frequently.
Furthermore, 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 enhanced security and liquidity. However, given the variety of funds available, an investor should carefully assess any fund and consult with financial professionals before investing.