The cash investment dilemma
Investors trying to populate the ‘cash’ asset class often have to make a choice between cash deposit accounts or money market funds.
Whilst both sit within the same overall asset class, they are quite different creatures. Understanding the difference between the two is essential from an investment perspective; particularly as they should both lie at the safer end of the investment risk scale.
The decision earlier this month by Threadneedle to close their UK Money Securities fund highlights some of the issues faced by these money market funds. This was the fund slated last year after a run of poor performance.
Last year also saw Standard Life having to bail out one of their money market funds after a period of poor performance leading to a unit price adjustment.
So just what are the differences between cash deposits and money market funds, and how should you decide where to allocate the ‘cash’ part of your portfolio?
Cash versus money market funds
Cash deposit accounts need little by way of explanation. It is safe to say that most investors have had some personal experience of these, via their bank or building society, in the past. In most cases you deposit your cash, it earns an agreed rate of interest and this is added to your capital. As the annoying Meerkat puppet from the price comparison adverts would say, “Simples”!
Money market funds are quite different.
Whilst they aim to deliver cash like returns, they do this by investing in a variety of cash instruments. These might include cash deposits, “near cash” instruments and short dated gilts. In basic terms, investing your money in a money market fund is not the same as placing your cash in a deposit account with your bank or building society.
Another key difference is charges. Whilst the profit is already priced in to the interest rate you get on cash deposits, with a money market fund you pay an annual management charge (AMC) to the fund manager. These vary depending on the specific fund, but are typically lower than the AMC you would expect to pay on other investment funds. For example, BlackRock Cash has an AMC of 0.4%.
The Money Market sector
The IMA Money Market sector has had a reasonably good twelve months, even in light of falling interest rates on cash.
The top performing fund over the past year has been Invesco Perpetual Money. It has returned 3.97% compared to a sector average return of 0.94%. Most very cautious investors would be satisfied with nearly 4% against a Bank Rate of 0.5%. Even the sector average return is nearly twice as much as the Bank Rate.
At the bottom of the pile is Threadneedle UK Money Securities, already marked for closure by 14th December 2009. This fund has returned -21.67% over the last year. Investors who were expecting cash like returns from this fund would be rightly disappointed to lose over a fifth of their investment during the past twelve months.
When things go really wrong
After the near collapse of the global banking system, more people than ever before are now well versed with the intricacies of the Financial Services Compensation Scheme (FSCS). This is the scheme which provides protection to savers and investors in the event of a regulated firm being unable to meet liabilities. It is an important safety net and has been beefed-up as a result of recent banking shenanigans.
With a cash deposit in a UK regulated financial institution, the compensation rules are pretty easy to understand. It covers 100% of deposits of up to £50,000 per person. This applies per firm and per type of claim.
It is important to note that any liabilities (such as mortgages or loans) you have with an institution would get knocked off the value of your savings before a claim was assessed, so having more debt than savings with one bank can effectively wipe out your FSCS claim if they went bust.
Money market funds work differently. If the provider of a money market funds were unable to meet liabilities, the FSCS would still apply, but it would operate under slightly different rules.
Investment funds are covered with a total compensation limit of £48,000 per person, per firm. This is made up of 100% of the first £30,000 and 90% of the next £20,000.
However, by using a money market fund you should be spreading the risk associated with a single bank or financial institution going under. The fund manager will be diversifying your money by investing in a range of firms, reducing the risk that the collapse of one bank will force you to fall back onto the FSCS.
Why money market funds?
The main reasons for using money market funds rather than cash deposits are the potential for better returns and access issues.
I have already mentioned one benefit associated with diversification within money market funds; namely the reduced risk of one firm going bust wiping out your entire holding and forcing you onto the terms of the Financial Services Compensation Scheme.
Diversification should also work in your favour in a fluctuating cash market, where interest rates on offer are rapidly changing. The fund manager will be doing all of the hard work on your behalf, to ensure they are taking advantage of the best rates on offer, rather than forcing you to regularly shop around for a better deal.
Access is the thing that drives many investors to use money market funds instead of cash deposits. Put simply, many investment vehicles do not provide access to cash deposits. Invest your money in a personal pension, for example, and it is unlikely that you will be able to select a bank or building society account as an investment option.
Things get better if you are using a Self Invested Personal Pension (SIPP), where you should get access to a range of both options.
The most important lesson is that money market funds differ from cash deposits. They might get lumped together under the same broad asset class of ‘cash’, but they behave differently and get treated differently in some circumstances.
Know the differences and put yourself in a much better position to make a suitable decision with your money.
Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice.
