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You may find yourself in a situation where you have cash in your stocks and savings account. Now, what can you do with that money to keep it safe for a short period of time without taking much investment risk? Well, the ideal candidate for your investment would be a money market fund, a low risk, low return investment, which isn’t to it’s as safe as cash, but very close. So let’s look at that in a bit more detail.
This is not a recommendation. If you want advice, tell it to your specific circumstances. Seek independent financial advice. Let’s start with a definition of money market funds. Here’s a tweet from Paul Louis, the presenter of the money box program on radio fall in response to an article in The Sunday Times about Vanguard’s new short term money market fund. And he has a mini rant where he says, Shame on Vanguard, who was one of the good guys and still is for tracker funds. He says This absolutely is not cash in.
It’s risky Now I consider pull Louis to be a national financial treasure, and I love him dearly. But after this tweet, I love him a little bit less is the definition of a money market fund from Baron’s Dictionary. So firstly, it’s an open ended fund, which means that as more people put money in the size of the fund, expands on the type of assets in which the fund invests include commercial paper, which is like extremely short term loans to companies you can think of them a short term corporate bonds on all of these assets.
Bankers, acceptances, repurchase agreements, government securities and certificates of deposit are all highly liquid and safe. Security’s on because the risk is very low. You get a very small return those money market rates of interest. So the key points of the money market account is, firstly, that it’s liquid, by which we mean you can sell the fund and turn it into cash very quickly. The interest rate risk is extremely low because the duration of the fund is extremely short.
Remember that if you’re locking in a rate for a long period of time, you become much more sensitive to interest rate fluctuations on the credit risk, which is the risk of loss because you’re counterparty refuses to repay you is extremely low because all the investments of a money market fund have an extremely high credit rating now, Normally, when you invest, do you think about return on capital by investor 100,000? And I want to get the highest possible return on that with the money market fund, you’re much more concerned about return off capital. So the key thing is for the value never to be below the amount you put in.
So now let’s look at a large US money market fund to see how it’s structured. Money market funds really took off in the 19 eighties, when interest rates were very high. Notice how they spike whenever there’s a recession, which is thes gray bars because people get scared and they want to preserve their capital. But even during the good times, you get a very large growth in money market funds, and currently the size of US money market funds is about $3 trillion but it’s a very large market.
This is a J. P. Morgan Prime Money Market fund. Its objective is current income while seeking to maintain liquidity, which means that you can sell the fund very quickly on a low volatility of principle. It can only invest in high quality, short term obligations, which present minimal credit risk. And when it does by commercial paper, it only invest in the highest credit category. Now the purpose of the fund is for temporary or medium term cash investments or, if you want some liquidity component of your portfolio. In other words, that’s a part of your portfolio, which you can draw on a very short notice without worrying about it crashing in value. And here’s the effective maturity of its investments.
You can see that the longest materiality of the investments is 180 days, which is about six months, and by far the largest category of its investments is in certificates of deposit, which are very low credit risk. And they have very little duration. It’s a very little interest rate risk. If we look at the price of the fund over time, you can see it’s extremely boring. It’s always close to one, and it’s been there since 2015. So if you’re invested dollar, you get your dollar back. Since 2009 interest rates have been almost zero. But when the feds started to increase rates in 2016 the return on the fund went up. But if the Fed carries on cutting rates, the return on this will fall again. And that’s because of Federal Reserve controls.
The short term interest rates in the United States, which also determines the return on this fund. The dividend is paid at the end of every month and for a dollar investment, these air the payments you’d receive, and they’re absolutely tiny. The most important rule for one of these money market funds in the U. S. Is it must never break the buck. If you put in a dollar, you expect to be able to take out that dollar. As this article said in the FT in 2007 money market funds should never break the buck or allow net asset value to fall below the face value. Asset managers would rather have their teeth pulled than suffer this hit to their reputation. And, as you probably guessed in 2008 here’s another FT article about the first fund to break the buck on.
The fund was fairly large. It was about 65 billion in size. Not only did it break the buck, but people couldn’t pull out their money immediately. Redemptions, which is when you take out your money, were delayed by seven days. And the reason for the full was that the commercial paper in which the funded invested was alone to Lehman Brothers, which of course, defaulted in September 2008. But fortunately, the story ended well, and in 2014 the U. S. Federal court announced that investors would get 99.1% of their investments back. But it certainly took a long time. Now let’s look at some U. K money market funds.
If you look for the sector on Morning Star thes air, the 25 funds that you come up with and as you’d expect the year to date return, is fairly small for all of them. If we look at the Invesco money funded detail, you can see that the ongoing charges 0.25% per year. And unlike those US money market funds, this is an accumulation fund on what that means is that instead of having a fixed amount, the price of the fund increases as the income is reinvested back into the fund. And that’s why the price of the fund steadily increases. And if you look at the maturity range of the investments for the fund, you can see they’re very short.
Almost all of the investments have a maturity of less than one year and Justus for the U. S. That’s to reduce the interest rate risk. If we look at the cumulative return on that fund, you can see it has two very clear phases. One of them is from 1999 until 2010. On the 2nd 1 is from 2010 to the present day. And the reason for this dis continuity is a global financial crisis, because that’s when the Bank of England reduce rates almost to zero. And as a result, the total return on this fund went from about 4% peer down by a factor of 10 to just 100.4% per year. And given the fact that global growth seems to be decelerating, it’s likely that rates will stay low for some time to come. So probably pays to listen to what the Bank of England says, because they’ll certainly signal whether they’re about to raise rates will keep rates where they are currently. And although it’s not identical. That bank rate will pretty much determine what you’re going to be paid for money market funds.
So as we saw, the interest rate fell from around 5% to almost zero after the financial crisis. Now, one thing to watch out for for these funds is also the ongoing charge. You want to pay as little as possible for your money market fund, but you could see this huge variation in fee with the Air Cy Sterling Money Market Fund charging only 10.5% per year, whereas this fun child is almost 12 times as much a 0.58% per year. So just to be absolutely clear, the money market fund is not a cash ISA or individual savings account. The first difference is that the rate your paid will be considerably lower than you’d get with a cash icer.
Another difference is that you don’t get any kind of guarantee from the government, which preserves your capital, and you would get that with a cash writer up to a limit of 85 K in 2019 per authorized company. And where are some people? See Akash Icer is a long term investment you should be absolutely clear that a money market fund is a safe, short term plate. The cash storage or possibly as part of your portfolio that you could draw on in times of emergency money market funds certainly shouldn’t constitute a significant part of your long term asset allocation. And the reason for that is that you’re almost guaranteed to lose money in these funds. If we plot the bank rate in the U. K. Over time against the rate of inflation in the UK, you can see that inflation has been significantly higher than a bank rate since 2010. And that means that in real terms, when we subtract the rate of inflation from your money market fund return, you’ll end up with a negative return, which means that the amount of goods and service is that you can buy with your money decreases over time.
Your long term goals should always be to exceed the rate of inflation, and certainly at the moment, money market funds guaranteed not to do that. And that’s why it’s certainly not a long term investment. You’ll pay a price to park your money safely, but if we look at current cash Aisa rates as of August 2019 you’ll notice all of those are also below the rate of inflation. So in real terms, when we subtract the rate of inflation, those will be generating a loss. But they are higher than the rate you get with the money market fund, so the loss would be smaller. So let’s go back to that Vanguard money market fund that Paul Louis was talking about in this article. They say very clearly what it’s designed for.
It’s designed to hold your savings rather than growth. Um, and it’s a means to provide a vehicle in which to hold your capital while maintaining high levels of liquidity and generating a slightly higher return than cash. But they say very clearly that low risk doesn’t mean zero risk, so it’s still possible to get back less than he put in. But the real attraction of this fund is it’s very low ongoing charge, even though it’s actively managed. And of course, the risk is a lowest category that Vanguard offers only one out of seven, and then the investment strategy is very clear that the fund is not recommended for investors seeking long term capital growth. But it will provide capital stability, liquidity on diversification. And, although it’s limited at at least, tries to maximize current income with the very safe instruments at its disposal, this fun hasn’t been around very long.
When I make this video, you can see that the constituents have a very small maturity on average, only about 43 days. And that means the interest rate risk is very small because we’d expect the credit quality is very high, so you don’t have to worry too much about credit risk. But of course, we all remember what happened with Lehman, and the types of investment are also very safe. So a lot of UK Treasury bills, which is short term loans to the UK government and U K Commercial paper, which is short term loans to UK companies but also some very safe bank instruments like certificates of deposit on time deposits and the price of the fund, is very reassuringly boring, with the net asset value hovering very close to £1. If you get the income version of this fund, it’ll pay out monthly, but it’ll pay after tiny amount just 0.62% as of 16th of August.
So money market fund fulfills that role of a low risk, low return investment where you can park your capital for short periods of time in your eye, sir, or your sip. Now, if you want to see these videos continue, please consider supporting us on patriots. Just click on the buttons above to subscribe on for $5 a month. You could join us on our weekly call and join us on our slack channel and ask any question you like. And if you pay $15 you get a 1 to 1 with me every other month on as always, Thank you for listening.
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