How to choose between money market funds

The banking crisis triggered by the collapse of Silicon Valley Bank and subsequent regional US banks in March 2023 made depositors realise that there can be potential risks with concentrated bank deposits. Together with rising short term interest rates, the Financial Times reported that US money market fund assets have swelled to record US$5.4 trillion in May 2023.

For those who are not as familiar with what these instruments are, here is a primer on money market funds (MMFs) and how to choose between MMFs, as there are different risks, and correspondingly, different yields that exist between money market funds.

Understanding what this instrument is, and being aware of and understanding the risks of the underlying MMFs will better equip us to choose between the options available to us.

What are money market funds (MMFs)?

A money market fund (MMF) is defined as a fund that invests primarily in short-term deposits and high quality money market instruments such as government bills, certificates of deposit, commercial papers, short-term notes and banker’s acceptance. These funds offer high liquidity with a low level of risk.

In Hong Kong, the Securities & Futures Commission (SFC) has strict regulation on the investment parameters for MMF as stated in Paragraph 8.2 of the Code on Unit Trusts and Mutual Funds including weighted average maturities, concentration thresholds, types of underlying instruments and borrowing limits etc.

How to choose between money market funds (MMFs)

Skill of fund managers

Money market funds are managed actively by fund managers who aim to help its investors get higher returns, based on the investment mandate given to them. The fund managers have to stick closely to the funds' investment mandate, therefore there is assurance that there would not be inappropriate risk taking behaviour from the fund manager.

In the case of the Ping An USD Money Market Fund, it is stated that in the fund document that "The Sub-Fund seeks to achieve its investment objective by investing primarily (i.e. not less than 70% of its NAV) in USD-denominated and settled short-term deposits and high quality money market instruments issued by governments, quasi-governments, international organisations and financial institutions. The Sub-Fund may invest up to 30% of its NAV in non USD-denominated short-term deposits and high quality money market instruments. The Manager will hedge any non USD-denominated investments into USD in order to manage any material currency risk.”

Another example of a money market fund is the Abrdn Liquidity Fund USD. It is stated that in the fund document that “the assets of the Fund are invested with the principle of risk diversification predominantly in fixed or floating US Dollar denominated Money Market Instruments and in deposits with credit institutions, including but not limited to, fixed-term deposits at financial institutions, certificates of deposit, commercial paper, ABCPs, medium-term notes, short-term treasury bills, floating rate notes, Asset Backed Securities and call and notice accounts.” 

Within this framework, the fund manager has to be able to manage the fund and optimise returns to be able to get a higher yield for its investors.

Size of the fund

The total fund expense borne by the fund, or more commonly known as the total expense ratio, is made up of a variable cost component and a fixed cost component.

As the fund size grows bigger, while variable costs increase accordingly, fixed costs remain the same and thus average costs are lower overall. Consequently, the total expense ratio of the MMF, as with the case of other unit trusts or Exchange Traded Funds, will be lowered. This may in turn translate to a higher return.

Are there risks to money market funds (MMFs)?

Ultimately, MMF is a type of fixed income fund that invests in debt securities characterised by their short maturities. Albeit risk levels are low, they are also subject to risks typical to fixed income investments.

Credit risk

Credit risk is quite simply defined as the chance of a loss arising from a borrower not being able to repay a debt. MMFs and similar variants can either hold debt from corporate or government entities, or lend money to financial institutions.

The risk of default from the debt and loan holdings of an MMF is low compared to high yield bonds because of the credit quality of the issuer or counterparty.

Interest rate risk

Interest rate risk is associated with the sensitivity of a debt or loan to changes in interest rates. If interest rates increase, the value of a money market fund’s investments generally declines, and vice versa.

Interest rate risk of a money market fund can be measured by weighted average maturity (WAM) and duration. Higher WAM or duration of a money market fund means higher interest rate risk.

Aside from general investment risk and risks associated with debt securities, MMFs may also have the following key risks: risk relating to valuation method, risks relating to reverse repurchase transactions, risks of investing in other collective investment schemes, currency risks, emerging market risk, negative yield risk, and more.

Key personal considerations for choosing between MMFs and its variants

Now that we understand the different risk levels of MMFs and similar products, we should understand how our personal finance circumstances and considerations can affect our decisions.

MMFs are meant to be a safe vehicle for us to store wealth, rather than grow our money for inflation. When we deliberate on whether to put our money into MMFs, we need to consider if the 2-3 business days needed for the funds to be withdrawn is quick enough for us.

We also need to consider the risk involved, be it credit risk or interest rate risk. If the money is meant for a short-term store of wealth for expenses needed in 1-2 months time, then it is safer to consider investing in an MMF where there is very low risk. However, if you want slightly more yield and intend to hold your money for 6 months or more, then investing in a slightly riskier product such as cash funds or ultra-short duration bond funds. 

With a better understanding of the different risks involved, you are now more informed and equipped to choose the right cash management solution for yourself.

To explore money market funds and cash management options on the Endowus platform, click here to get started.

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General risk warnings relating to collective investment schemes 

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