A money market fund (MMF) is an open-ended investment fund that holds short-term debt issued by governments, banks, and large corporations. MMFs play an integral role in the global financial system as pools of short-term funding for organisations such as governments, pension funds, insurers, companies, local authorities, and charities.
Money market funds have also acquired a secondary function as a cash reserve for ordinary ‘retail’ investors (that’s us!) chasing a better rate of interest than they can get from a bank account or cash ISA.
But is the higher yield potential of a MMF worth the extra risk that comes with them? We’ll aim to answer that question – and more – in this guide.
What are the main investment objectives of money market funds?
The primary investment aims of money market funds are:
- Stability
- Daily liquidity
- Credit risk diversification
- Returns aligned to the prevailing money market rate
Because MMFs are relatively stable investments they’ve been marketed to ordinary investors as ‘cash equivalent’ products.
However while money market funds are low volatility, their extra yield does come with additional risk strings attached.
Moreover, those risks are most likely to materialise during a period of heightened market stress, when ready access to cash is paramount.
Are money market funds considered to be cash?
Money market funds should not be thought of as cash. The Financial Conduct Authority (FCA) makes this point crystal clear in its Resilience of Money Market Funds [1] paper:
As an investment, MMFs do not guarantee principal, and the investor must bear the risk of loss. MMF investments are equity liabilities, unlike bank deposits which are debt liabilities whose value is supported by equity capital.
It is true that money market funds are low-risk in comparison to equities and bonds.
But MMFs are riskier than cash because:
- They offer same-day redemptions to their investors
- But the majority of their assets are less liquid than cash and may not be immediately sold
This means there’s the potential for a liquidity mismatch if too many MMF investors make a ‘dash for cash’ during a market shock.
Under extreme conditions, money market funds can struggle to meet investors’ demands for their money back. That is exactly what happened during the Global Financial Crisis and the Covid crash.
It’s an extra dimension of risk for investors who think of their money market fund as a cashpoint.
What’s inside a money market fund?
It becomes obvious that money market funds aren’t just cash when we look at the list of financial instruments they typically invest in:
- Commercial paper (unsecured, short-term corporate debt)
- Corporate and sovereign floating and fixed-rate bonds
- UK Treasury bills (ultra short-term government debt)
- Repurchase and reverse repurchase agreements (short-term borrowing and lending in government securities via the repo market [2])
- Bank certificates of deposits (CDs)
- Cash deposits
This chart shows the break down of assets held by GBP money market funds:
[3]Source: FCA. Resilience of Money Market Funds. [1]
And here’s a typical list of the top ten holdings from a single money market fund:
[4]Source: Vanguard. Sterling Short-Term Money Market Fund. [5]
As you can see we’re not just talking about cash.
Do money market funds pay interest?
Money market funds do pay interest, but the rate is variable and not guaranteed. You won’t see an annual interest rate attached to a money market fund as if it were a bank account.
Typically, GBP money market fund interest payments resemble the Sterling Overnight Index Average rate known as SONIA.
The benchmark SONIA rate is supervised by the Bank of England. It is aligned to the overnight borrowing costs of banks.
You can check out the latest SONIA rate [6] for yourself.
The next chart shows how SONIA has risen in the past year. Interest rate fans should notice that SONIA is closely tethered to the UK’s official Bank Rate:
[7]Source: Bank of England.
Estimating money market fund interest rates
We can use SONIA to approximate the annual rate of interest available from a GBP money market fund.
However, SONIA can only ever be a rough guide to MMF income payments because:
- SONIA fluctuates daily
- Payouts from a money market fund are net of fees
So we must deduct all our investment fees from SONIA as part of our interest rate estimate.
For example, let’s say today’s SONIA rate is 3.92%.
From that you would deduct your following investment costs:
- The MMF’s Ongoing Charge Figure (OCF) – e.g. 0.11%
- Transaction costs (the fund’s underlying transaction costs [8], applicable spreads [9], and your broker’s dealing fees, if any.) – e.g. 0.01%
- Your broker’s platform fee – e.g. 0.25%
Your potential money market fund interest rate is thus:
3.92% – 0.37% = 3.55%
Money market funds are actively managed so some may beat SONIA periodically, or even over long periods of time. That’s hard to gauge with reasonable certainty, and isn’t guaranteed. Personally, I’d treat anything extra as a bonus.
Comparing your estimated money market fund interest rate against a bank account
Pop your estimated money market fund interest rate into a compound interest calculator such as this one [10]. Match your inputs to the calculator’s fields like this:
- Initial investment = £1
- Interest rate = 3.55% yearly (or whatever is your estimated MMF annual interest rate)
- Years = 1 (this ensures the calculator gives us an annual compound interest rate)
- Compound interval = Daily
- Effective Annual Rate = 3.614%
The calculator’s Effective Annual Rate is the figure to compare against the Annual Equivalent Rate (AER) touted by your bank account. It gives us an apple-to-apples compound interest comparison.
Both rates assume you reinvest your interest throughout the holding period.
However you won’t get exactly this rate if you hold your money market fund for a year. Your MMF may not track SONIA perfectly. And SONIA varies daily in any case.
But at least this calculation provides a way of estimating if a money market fund offers any kind of interest rate advantage over a bank account.
Other money market fund yields
On a money market fund’s webpage you may see a percentage rate called something like ‘dividend yield’, or ‘net yield’, or ’12-month trailing yield’, or similar.
Such yields are typically calculated by summing up the last year’s worth of interest paid divided by the fund’s current price or Net Asset Value (NAV).
- If interest rates are rising then a trailing yield will probably underestimate your near-term income from the fund.
- If interest rates are on a downward trend then a trailing yield is likely to overestimate your expected income.
This assumes that your principal remains absolutely stable. We’ll explain why you can’t take that assumption to the bank shortly.
Note: your interest is automatically reinvested if you choose an accumulation fund [11].
An income [12] money market fund will pay out interest at the frequency indicated on the fund’s webpage.
Are money market funds taxable?
Yes, any interest or excess reportable income [13] earned is taxable at your marginal rate of income tax as per normal cash savings.
Money market funds will often describe their income distributions as dividends. However they are taxed as interest.
There’s no tax to pay if you hold your money market fund in a stocks and shares ISA [14], or pension.
Your Personal Savings Allowance might also shield your MMF interest payments earned outside tax shelters from tax, depending on how much you have saved.
The Personal Savings Allowance enables non-taxpayers and basic rate taxpayers to earn £1,000 of interest tax-free. The amount is £500 for higher-rate taxpayers.
Low earners may be eligible to earn another £5,000 in tax-free interest using the little-known starting rate for savings [15].
Does your money market fund pay interest gross or net?
If your money market fund is registered as an OEIC or Unit Trust then check if it pays interest gross or net.
If interest is paid net then you’ll receive it with 20% income tax already deducted.
- So a basic-rate taxpayer has no more to pay. (Yay!)
- A higher-rate taxpayer owes another 20%
- A non-taxpayer is due 20% back (Double yay!)
This is only an issue if you’re holding the fund outside of an ISA or pension. It’s also not relevant if your fund pays interest gross – that is, with no tax already deducted.
Scan the fund’s webpage or other documentation for the info. Or contact the fund manager directly for clarification.
Capital gains tax [16] (CGT) applies as usual.
If you invest in a foreign-domiciled money market fund then check its webpage or factsheet to ensure it has UK reporting fund [17] status. If not, then any CGT liability must be paid at your income tax rate.
Money market funds tucked safely inside an ISA or pension are exempt from CGT.
Can money market funds lose money?
Money market funds can lose money. They typically invest in low-risk assets and are subject to close regulation. But you’re still not guaranteed to get back all the money you invested.
The clearest warnings come from the money market fund managers themselves.
BlackRock’s Cash Fund [18] explicitly states the risk on its webpage:
Capital at Risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
A Money Market Fund (MMF) is not a guaranteed investment vehicle. An investment in MMFs is different from an investment in deposits; the principal invested in an MMF is capable of fluctuation and the risk of loss of the principal is to be borne by the investor.
BlackRock goes on to list some of the risks that money market funds are exposed to:
Loss of Capital: an automatic share redemption may occur which will reduce the number of shares held by each investor. This share redemption will result in a loss of capital to investors.
Counterparty Risk: The insolvency of any institutions providing services such as safekeeping of assets or acting as counterparty to derivatives or other instruments, may expose the Fund to financial loss.
Credit Risk: The issuer of a financial asset held within the Fund may not pay income or repay capital to the Fund when due.
These risks are not merely theoretical. A huge and reputable US money market fund called the Reserve Primary Fund [19] faced a run on its assets during the Global Financial Crisis in 2008.
Reserve Primary suspended redemptions and was eventually forced to liquidate its assets at a loss that impacted its investors.
The lessons of the Global Financial Crisis led to widespread reform of the $4.8 trillion [20] money market industry both in the US and in Europe.
The MMF sector was again severely tested at the height of the Covid crash. Major institutional investors pulled their money as they scrambled to solve their own liquidity problems.
Money market funds subsequently faced massive redemption demands. And these were amplified by the unintended consequences of the previous round of reforms.
Fortunately, central bank action alleviated the pressure. Another wave of reform [21] is now underway.
Cash crunch
The significant takeaway for ordinary investors is that – despite successive attempts by global regulators to strengthen money market fund resilience – what seems to be a low-risk vehicle in normal times can become unstable in extreme conditions.
The fact is that money market funds are not primarily designed to serve the needs of ordinary investors.
And the two most recent global crises illustrate that adverse feedback loops could restrict your access to cash at the worst possible time.
“Help! My money market fund is losing money” false alarm
If you do invest in a money market fund and you see an apparent capital loss shortly thereafter, check that you’re not being misled by the fund’s standard dividend payment operating procedure.
The following chart shows what looks like a repeating cycle of gains and losses by the Vanguard Sterling Short-Term Money Market Fund.
However, these share price fluctuations are just the regular monthly accumulation and distribution of interest from an MMF:
[22]Source: Vanguard. Sterling Short-Term Money Market Fund. [5]
Every month, the fund’s net asset value (NAV) rises above its £1 par value due to the accumulation of interest paid into the fund from its assets.
That accumulating interest temporarily fattens the fund’s value before it is distributed to investors.
The fund falls in value on its ex-dividend date. That’s when the interest payments are set aside by the management team in preparation for payment to shareholders.
Hence the apparent loss is entirely compensated for by the income you receive from the fund on its distribution date.
This cycle repeats as the money market fund continually harvests and pays out interest.
Note that despite the dramatic scale of peaks and troughs on the chart, the differences in NAV amount to a tenth of a penny on the pound.
(With all that said, your investment would be much more volatile if you held a MMF in a foreign currency as you’ll then be exposed to the gyrations of the FX market [23], too.)
Are money market funds safe?
Money market funds are not as safe as cash. The additional risk inherent in their operation subjects them to pressures and rules that don’t apply to a simple bank account product.
The Financial Stability Board (FSB) spells out the two main MMF vulnerabilities in its 2021 report [24] Policy Proposals to Enhance Money Market Fund Resilience:
- “They are susceptible to sudden and disruptive redemptions”
- “They may face challenges in selling assets, particularly under stressed conditions”
A wide range of large financial institutions use money market funds for cash management.
But some money market fund holdings have relatively limited liquidity, especially when markets are stressed.
This means that MMFs cannot guarantee daily redemption under all circumstances.
The cost of liquidating harder-to-shift assets can rise during a market slump, or dry up completely. This creates an incentive for some money market funds and their investors to redeem early in a crisis – before the cost of doing so increases, or the regulations impose firebreaks on selling.
The FSB comments that:
Taken together, these features can contribute to a first-mover advantage for redeeming investors in a stress event and thus make individual MMFs, or even the entire MMF sector, susceptible to runs.
The FCA spell out how this contagion spread during the Covid Crash:
In March 2020, financial markets reacted to the unexpected effect on economic activity of the Covid pandemic and the public health measures introduced to contain its spread. This shock exposed underlying vulnerabilities in the financial system, which catalysed an abrupt and extreme dash for cash. As a result, financial markets experienced increased selling pressure, volatility and illiquidity.
MMFs also came under severe strain across major currencies, including in sterling, as investors quickly sought access to cash. Investors redeemed their units in MMFs to make necessary payments elsewhere, such as margin payments.
However, some investors may also have redeemed or made additional redemptions partly due to fear of being unable to redeem at a future date.
Some MMFs struggled to maintain the required liquidity levels as set out in law and regulations, which increased the perceived (and actual) risk of funds being suspended, which in turn may have increased investor outflows from some MMFs.
I think that conclusively answers the question: “Are money market funds safe?”
UK and European regulation can impose the following penalties on MMF redemptions:
- Additional liquidity fees
- Restrictions on the amount you can withdraw (known as ‘gating’)
- Suspending the fund
- A low-risk MMF must transform to a riskier type if it’s suspended for more than 15 days within a 90-day period
These penalties could make life more difficult for an ordinary investor who needs cash in a hurry.
As citizens, however, we should be reassured to see such measures that aim to protect the wider financial system from the systematic vulnerabilities of MMFs.
Money market fund classification
There are four types of money market fund available in the UK and Europe.
From the most conservative type to the least, they are:
Public Debt Constant Net Asset Value (PDCNAV) MMFs
- 99.5% of assets must be invested in public sector debt issued by central government, local authorities, and quasi-governmental bodies.
- Investors are able to buy and sell at a constant NAV price of £1 calculated to two decimal places. Volatility should be minimal under normal circumstances.
Low Volatility Net Asset Value (LVNAV) MMFs
- Can invest in private debt as well as public sector securities.
- Otherwise, liquidity requirements are as stringent as those that apply to PDCNAVs.
- The fund’s price is maintained at a constant £1 NAV under normal circumstances.
Short-term Variable Net Asset Value (STVNAV) MMFs
- Liquidity rules are looser than with the first two MMF types.
- Pricing is variable, meaning capital gains and losses are possible under normal circumstances.
Standard Variable Net Asset Value (VNAV) MMFs
- The least restricted money market fund type.
- Enjoys the wider liquidity bounds of a STVNAV but adds longer maturity assets to the mix.
- Variable pricing.
The FCA produced this table summarising the liquidity and maturity restrictions governing the four different money market fund types:
[25]Source: FCA. Resilience of Money Market Funds. [1]
- DLA = Daily liquid assets – the percentage of assets that can be disposed of in 24 hours
- WLA = Weekly liquid assets – as above but disposal is allowed within a week
- WAM = Weighted average maturity – the average time taken before the fund’s current holdings will be repaid by their issuer
- WAL = Weighted average life – the average time taken before the fund’s holdings will repay the amount invested. Similar to Macaulay duration for bond funds
Risk is all relative
Compared to the differences between, say, equity funds, all MMFs are so conservative that it’s like comparing four Mrs Thatcher clones by the colour of their headscarves.
However, the FCA draws out this key distinction:
As noted, evidence from major MMF domicile jurisdictions strongly suggests that in a large-scale market stress, private sector-backed MMFs suffer large outflows, while public debt backed MMFs receive large inflows. LVNAV MMFs invest predominately in private sector assets, while the PDCNAV must invest almost entirely (minimum 95.5%) in public sector assets. The evidence also indicates that public sector debt markets are less likely to become seriously illiquid in large market stresses than private sector debt markets.
Your money market fund provider may mention what type it is on the product’s webpage or somewhere within its documentation. (Burying the info somewhere within a 200-page prospectus is a favourite wheeze. World’s. Worst. Word search.)
You can find more detail about the money market fund classification system [26] here.
Does the FSCS compensation scheme apply to money market funds?
If a money market fund provider defaulted then you’d be entitled to a maximum payout of £85,000 per authorised firm [27] – including their sub-brands. Sadly, the restrictions of the FSCS compensation scheme [28] means that limit is the most you’re entitled to. That’s regardless of how many investment funds you own from that provider. The £85,000 does not apply per fund.
Moreover, the FSCS scheme does not cover investments – including money market funds – that are domiciled outside the UK.
If you own investments in Ireland or Luxembourg then you’re subject to the statutory compensation scheme followed by those countries. This limits compensation payments to a meager €20,000.
Best money market funds
You can buy and sell money market funds from investment brokers [29] like any other fund.
Not every broker makes it easy to find MMFs on their platform, however. Your best bet is to drop the name of your favourite money market fund into your broker’s search bar.
But how do you compare money market funds in the first place?
For money market ETFs, use justETF’s ETF screener [30] switched to the money market category.
There’s only a handful of prospects. You can easily compare them using justETF’s tools.
Note that some of the products are synthetic ETFs [31] that use a financial derivative called a total return swap [32] to match the SONIA rate.
For a broader trawl, go to Morningstar’s Fund Screener [33].
Flip the screener’s Morningstar Category to GBP Money Market – Short Term or GBP Money Market.
Compare the characteristics of your candidate MMFs using Morningstar’s Investment Compare [34] or the slicker FT Fund Compare [35].
Personally, I’d concentrate on:
- Long-term performance – Morningstar show up to 10-year annualised returns where available
- Fees – Money market funds are typically actively managed and costs vary a great deal
- Assets under management – big is beautiful
- 12-month yield – to gauge how generous previous interest payments have been
- MMF classification – this will require a deeper burrow into the fund documentation
Still want a money market fund?
The pros of a money market fund are typically advertised as:
- More diversified than cash in bank
- May offer juicier interest rates
- No early withdrawal penalties (not entirely true as we’ve seen)
Yet having done the spadework on money market funds I can’t imagine why I’d choose one over a decent instant access savings account, except where tax comes into the equation and for some reason you don’t want to use a cash ISA.
There’s another narrow use case for someone who wants to earn a little more on cash that would otherwise be parked in a SIPP at derisory rates.
But I can’t see that the extra smidge of interest is worth it versus the additional risks you’re running with a money market fund.
If you want the simplicity and safety of cash [36] then put your money in a bank.
Take it steady,
The Accumulator