What are money market funds and why are they suddenly popular?

For much 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 difference between earning nothing and earning a competitive rate. That has changed. With the Bank of England (BoE) base rate climbing to 5.25% last year and currently standing at 4.5%, a meaningful return is available on cash.

In this context it is no surprise that investor attention towards money market funds has picked up, but what are these investments? What are the risks? And how much return can you expect?

What is a money market fund?

A money market fund is an open-ended investment fund that invests in a diversified portfolio of cash deposits and money market instruments. Depending on the remit of the individual fund, they may also include high quality, shorter term bonds that pay either a fixed or floating rate of interest.

The goal is to produce a competitive cash-like return from the interest received on the investments in the portfolio and to provide short term accessibility for investors. UK money market funds typically aim to produce returns that match or slightly beat 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.

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).

How much do money market funds pay?

Presently, SONIA is a little over 4.4%, which gives an indicative annual rate that investors can currently expect to accrue in a money market fund. However, what is actually received depends on the direction of short term interest rates. Were the Bank of England to cut interest rates, SONIA would also likely fall and interest rates available to money market funds would decrease too.

For holders of very short-dated deposits the effect is rapid, although longer-dated assets might be locked into a certain rate for longer.

Can money market funds lose money?

Unlike cash in a bank or building society, money invested in a money market fund is not protected or guaranteed. There is a chance that an investment, or a number of them, in a fund could fail in the event of highly stressed circumstances such as a bank or other entity going bust and the underlying deposit or investment in the fund not being made whole. Money market funds invest in high-quality assets, companies and government-related entities, so they are considered to be low risk but they are not risk free.

There is also a small risk that investors may not be able to redeem their holding in a money market fund on a given day, as there is with any open-ended fund. Money market funds typically have a significant proportion of investments that are short dated and very ‘liquid’ – that is to say easy to enter and exit readily. This means in normal circumstances they can meet any redemptions on a day-to-day basis with ease. However, because a portion of a money market fund is in assets with longer maturities, in exceptionally stressed markets this cannot be absolutely guaranteed.

How can money market funds be used in a portfolio?

Holding significant amounts in cash over longer periods of time is generally a wasted opportunity. Cash typically does a poor job of keeping up with inflation over longer periods, even if you are able to secure a competitive rate. Over the longer term, other assets that provide extra return and growth, albeit at the risk of short-term fluctuations, tend to be a better means to preserve and grow wealth.

Nonetheless, money market funds may be a consideration when the stock market is volatile, interest rates are meaningful, and investors aren't sure where to turn. They also could offer positive returns in an environment of rising rates and tightening of financial conditions, something that adversely affects traditional fixed income safe havens such as government bonds. They can therefore represent a tactical position for those anticipating difficult markets, or perhaps diversification from traditional bonds, especially longer dated securities, if there are concerns interest rates will rise or remain high for longer than expected.

They can also be an option where investors wish to derisk their portfolio, either in part or whole, because they are looking to draw on it in the shorter term.

What are costs of money market funds?

Like any fund, money market funds have charges, and although these are typically small, they eat into the returns investors receive. On any day where the return less costs and expenses of the fund is negative it will see a decrease in value. Indeed, when interest rates were close to zero, money market funds struggled to make any return at all for investors after costs. However, with interest rates now meaningful these funds become a more viable option. Don’t forget any platform fees and dealing charges also add to your cost of holding funds, including money market funds.

Are there any money market funds on the Preferred List?

Our Collectives Research Team has identified a fund that may be worth considering for those with the specific requirement of receiving a competitive cash-like return with low (but not no) risk within their ISA, JISA SIPP or Investment Account.

Just remember while there can be reasons to park in cash for a period, doing this with a significant proportion of your assets for an extended period can be damaging over the longer term as inflation will tend to erode its value.

Blackrock ICS Sterling Liquidity (Premier Class) comes with competitive annual ongoing charges of 0.10%. The fund’s primary aim is the preservation of capital and liquidity through the maintenance of a portfolio of high-quality short-term money market instruments.

BlackRock is one of the world's largest Money Market fund providers, and with size comes scale, resources and buying power. Benchmarked against the aforementioned SONIA rate, the fund contains mainly first-tier securities with very high credit ratings.

We now include it on the Charles Stanley Direct Preferred List of fund ideas across the major sectors for new investment.