What Are The Risks Of Investing In The Money Market?
Instead of sifting through hundreds of seemingly equal investment options, you decide to ask a friend, who has a background in finance, to point you in the right direction.
“Invest in the money market,” she tells you confidently. “You’ll receive higher returns and you’ll still be able to access your money overnight,” she adds with a nod. But what is the money market? And should you invest in it?
Defining the money market
According to Michael Kransdorff, chief economist at My Treasury, an online company that helps South Africans compare savings accounts, the money market is where large firms, governments and banks trade in short-term loans (under 12 months). Money market instruments, such as treasury bills, commercial papers, and banking deposits, are sold to investors to raise these funds.
For example, if a bank requires R1 million to cover its operational costs, it might sell money market instruments to raise this money. Investors then purchase these instruments, and they receive interest in return.
Fund vs. Account
Banks offer money market accounts as their personal money market instruments. Individuals who invest in these accounts receive a certain interest rate and their full investment goes towards that bank. According to Ancley Jacobs, CEO of First National Bank Cash Investments, these are ideal for storing money over the short, medium or even long term.
“Money market accounts may differ in terms of the minimum opening deposit, time to access the investment, interest rate composition, fees, and transactional capability,” says Jacobs. “Like other savings and investments accounts, money market accounts can be used to save for unexpected expenses, emergencies, specific goals, or special occasions,” he adds. Money market funds, on the other hand, are managed by asset managers at investment firms, and they offer a diversified portfolio of money market instruments.
“You are effectively lending your funds out to a group of low-credit-risk borrowers,” says Kransdorff.
Single bank risk: Money market account
He explains that money market accounts are solely invested in one bank, while money market funds are diversified across various entities, including banks. “In the case of a money market account, you are taking a credit risk on the individual bank in which you invest your money,” says Kransdorff.
According to Dave McCall, executive of investments, retail and business banking at Nedbank, this means money market accounts have a “single bank risk”. Since the full investment lies with one bank, it also becomes dependent on how that bank performs. If the bank becomes insolvent, investors may lose their money.
For example, when certain banks in South Africa became insolvent, those who had invested in their money market accounts had their funds put at risk. But, because of its composition, money market funds don’t have a single bank risk. Instead, they have a more diversified portfolio risk from various money market investments.
“A money market fund is similar to a unit trust, where you would effectively buy a unit of a fund which will give you a return on that fund relative to what an interest rate would be,” says McCall. “In contrast to receiving interest on a bank deposit, as is the case with a money market account, you will receive a return on your unit or investment,” he adds.
Capital risk: Money market fund
In order to enhance the yield on a money market fund, a portion of the fund consists of long-term assets. Depending on how the fund is made up, only a portion would be invested in 24-hour notice deposits. This means investors can withdraw their investments with 24-hour notice, but that there’s a risk they may lose some money. “Assuming everyone comes to ask for their money on the same day, the fund would have to somehow liquidate the longer-dated assets in order to meet the liquidity demand,” explains McCall.
Kransdorff explains that, if this were to happen, the fund manager may have to sell the longer-dates assets at a loss. As a result, investors may suffer a capital loss. In other words, they might receive less money than they initially invested.
How to decide what’s right for you
According to McCall, your choice between a money market account and a money market fund will depend on your risk profile.
“I think the reality is that if you’re prepared to forgo some of the safety of a bank deposit, for the chance of higher returns, you could opt for a money market fund. But you must fully understand the risks involved, as well as your own propensity to risk,” says McCall. “In many instances it’s still significantly lower risk than, for example, investing in an equity unit trust or directly in the stock exchange,” he added.
McCall believes there are three things you need to understand about your own goals before you decide where to invest your money:
1. You need to understand the duration of your investment and, therefore, when you will need the money. So, for example, if you’re going overseas at the end of the year, you don’t want to invest in a 12-month deposit because you will need to access the money.
2. Understand how much you would like to put in upfront, versus how much you’re prepared to put in on a monthly basis.
3. The longer you’re prepared to leave it for, the higher your interest rate is going to be. Understand what the worst-case scenario would be. For example, if you might need 50% of it, then only keep 50% of your money in a 24-hour notice deposit.
Kransdorff points out a money market fund will ultimately earn a higher return than most money market accounts. In turn, he illustrates how a money market account will nonetheless outperform a typical savings account in regards to its interest rate.
“Take Investec, for example: Their MoneyFund tracker account (a money market account), with an interest rate of 7.16%, pays almost 0.7% more than their PrimeSaver account (a savings account),” says Kransdorff. “While this may seem like a small amount on the surface, it can have a big impact in the long run due to compound interest,” he explains.
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