To understand money market funds, it's helpful to think about cash as an investment. For most of the past decade paying close attention to the interest generated on cash hasn’t been particularly fruitful. Interest rates close to zero meant little differential between earning nothing and earning a competitive rate. That’s changed.
Interest rates have risen and look unlikely to return to historically low levels in the short to medium term. We asked Steve Matthews, Fund Manager of the LF Canlife Sterling Liquidity fund to help explain why money market funds now offer an interesting low-risk option for investors within their portfolios, including within ISAs and SIPPs.
How should investors think about cash in the context of their investment portfolio, and how has this changed now interest rates are higher?
In near zero-interest rate environments (which have dominated since the great financial crisis in 2008), cash investments have generated little or no return for investors. Therefore, one could argue that their only value would have been as short-term strategic allocations to avoid losses in other asset classes.
However, with the Bank of England (BoE) base rate now standing at 3.5%, everything has changed. Of course, there is still the option to use the asset class strategically, but with a healthy income now being generated, money market funds (MMFs) can be considered a core investment within a portfolio, particularly due to the stable returns and low volatility offered.
How can money market funds be used in the current circumstances?
A money market fund is an open-ended mutual fund that invests in a diversified portfolio of short-term cash deposits, money market instruments and high-quality bonds (both fixed and floating rate). Its goal is to deliver excellent liquidity (MMFs settle much quicker than funds investing in other asset classes), capital stability (through the use of high-quality, short-term assets) and generating returns for investors in the form of the interest income received from these assets. This would be through coupons received from bonds or the interest rate received on money market instruments (Term Deposits, Commercial Paper & Certificates of Deposit).
In current circumstances, with yields at or near the level of UK gilts (with significantly less volatility and drawdown risk), we believe money market funds can be used as a core, defensive allocation within a diversified portfolio. This will enable investors to receive a healthy income yield and capital stability as well as providing sufficient liquidity to put money back into the market when views or situations change.
Need more detail on how money market funds work? Follow the link to find out more.
What sort of return can investors expect?
Money market funds aim to produce returns over and above benchmarks such as the BoE base rate and the Sterling Overnight Index Average (SONIA), which represents an average of short-term lending between UK financial institutions. Fund managers use their expertise in combining different types of assets that provide a mixture of quality, liquidity and yield.
Some MMFs focus on shorter-term, deposit-based instruments that typically track the BoE base rate. Therefore, your return expectation for these funds (on a 12-month basis), should be around this level. Other money market funds – such as the LF Canlife Sterling Liquidity Fund – take a slightly different approach and allocate to fixed-income assets, as well as deposits.
These earn a spread above the BoE base rate or SONIA, enabling the opportunity to gain an extra return. Therefore, you should expect to earn a return in excess of these rates over a 12-month period. However, the investment risk is higher than for funds that rely on pure deposits.
For tax purposes, money market funds pay interest, though there is no tax to pay if held in an ISA or Self Invested Personal Pension (SIPP).
Are money market funds liquid? Can you break down the various components that typically make up a fund?
The most important component in a money market portfolio is overnight deposits (held at various banks), which provide the daily liquidity required to meet any redemptions. Additional liquidity can also be provided by having a regular flow of maturing assets. These can be one to three-month Bank Certificates of Deposit (CDs) for example. These pay out interest on deposits made and are a key part of the bank funding market.
Funds also hold highly liquid government and other high-quality fixed-income investments from companies and agencies such as the European Investment Bank. The LF Canlife Sterling Liquidity Fund also has an allocation to Floating Rate Notes (FRNs). These are a specific type of bond investment whereby the coupon payable adjusts as the BoE change their base rate. This enables them to quickly adapt to new interest rate environments, particularly as rates are going up. Please see some of our current illustrative example holdings below.
Source: Canada Life Asset Management, December 2022. Examples are for illustrative purposes only. Market yields are variable and not guaranteed.
How do money market funds differ from one another?
All money market funds are highly regulated, and most are independently rated by a third-party ratings agency. They are required to provide high levels of liquidity and security by investing in short-term high-quality assets. For example, we only invest in bonds considered to be most securely rated, between AAA and A by well-known ratings agencies, maintaining an average rating of AA.
Once they have fulfilled these obligations, they have scope to follow different investment strategies in order to produce additional returns or liquidity. For example, we are currently adopting a ‘barbell’ approach, with a significant portion of the portfolio invested in one-day, one-week and one-month deposits to ensure we have plenty of liquidity. We are then focusing on finding slightly longer-dated assets (with 9-12 months maturity), to allow us to generate our investor's extra returns. Some of these examples were highlighted in the previous question.
How does a money market fund compare to, say, a cautious investment such a gilt fund?
A money market fund invests in short-term assets (generally with an average maturity of less than 6 months) to create a diversified portfolio of investments. These are considered to be very low risk from a volatility perspective.
A gilt fund is considered to be cautious because it invests in UK government assets. Therefore it is very low risk from a counterparty perspective. However, because the average maturity of these funds can be as high as 10 years (or 3 years in short-term gilt funds) there is a lot more volatility in the returns created. This can produce higher levels of returns, but in some markets, these funds do see significant losses.
So can money market funds lose money?
Because money market funds have short maturity profiles and invest in high-quality banks, companies and government-related entities, they are considered to be low-risk. However, as seen in the past, there is a small chance that an asset could fail in the event of highly stressed circumstances. The actions of regulators and fund managers over the last 15 years means there is more regulation, oversight and due diligence required on MMFs leading to more stability and more confidence in these funds. For example, at the height of the Covid-19 crisis in March 2020, the worst-performing UK money market fund lost just -0.2% before recovering.
How have money market funds stood up to previous bout of stock market volatility?
The global financial crisis saw some problems within the sector, as some funds (that pleasingly no longer exist) invested in low-quality, unsuitable assets. However, as mentioned, successive regulatory reforms have meant that the stressed liquidity conditions of the recent Covid lockdown in March 2020 saw all UK money market funds able to meet their liquidity calls without any concerns, justifying their tag as low-risk investments. This is highlighted in the graph below, which illustrates how money market funds are far less volatile – and protect capital more effectively – than other asset classes over the last twenty years.
Source: Morningstar Direct, as at 30/11/2022, in pound sterling. Maximum drawdown (measured daily) of the IA Standard Money Market, IA Sterling Corporate Bond, IA UK Gilts, IA Global and IA UK All Companies sectors since 2002. Sector returns represent the average performance of the funds within them
Source: Morningstar Direct, as at 30/11/2022, in pound sterling. Annualised volatility (measured daily) of the IA Standard Money Market, IA Sterling Corporate Bond, IA UK Gilts, IA Global and IA UK All Companies sectors since 2002. Sector returns represent the average performance of the funds within them.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested. Income from investments may fluctuate.
The LF Canlife Sterling Liquidity Fund is a UCITS scheme and a standard variable net asset value (VNAV) money market fund (MMF). The MMF is not a guaranteed investment, nor does it receive external support to guarantee its liquidity. Unlike bank deposits, investment in MMFs can fluctuate and Investors’ capital is at risk.
The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice.
This Q&A does not constitute a direct offer, or recommendation, to subscribe for shares in the fund. A full description of the risks of investing in the fund is set out in the latest Prospectus and Key Investor Information Document (KIID) available at https://www.canadalifeassetmanagement.co.uk/
No guarantee, warranty or representation (express or implied) is given as to the document’s accuracy or completeness.
Canada Life Asset Management is the brand for investment management activities undertaken by Canada Life Asset Management Limited, Canada Life Limited and Canada Life European Real Estate Limited. Canada Life Asset Management Limited (no. 03846821), Canada Life Limited (no.00973271) and Canada Life European Real Estate Limited (no. 03846823) are all registered in England and the registered office for all three entities is Canada Life Place, Potters Bar, Hertfordshire EN6 5BA. Canada Life Asset Management Limited is authorised and regulated by the Financial Conduct Authority. Canada Life Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
Are money market funds worth investing in?
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