Money market funds – what are they and why are they so popular?

With interest rates rising but the stock market volatile, there is evidence that investors are looking for ways to mitigate risk if they are remaining invested.

One popular strategy at present is buying into money market funds, funds that offer cash-like returns and near-cash safety within a pension or ISA.

Figures from financial data group Morningstar show that these funds were one of only two fund categories to receive net inflows from investors last quarter1, as investors are attracted by higher interest rates and seemingly low volatility.

But before you invest in a money market fund, it is important to understand exactly what is under the bonnet of your investment, as well as its safety profile and prospects for the long term.

Here are answers to some of the most pressing questions about these products.

Why do money market funds exist?

Money market funds exist as a place to put money for the short term, to get some return on it at a relatively low risk. They aim to deliver returns above the bank Base Rate by investing in debt that is likely to be paid off very shortly, as well as putting money into short-term cash deposits.

Investors use them to provide a high level of liquidity with a low level of risk.

Why are they popular now?

When interest rates were low, money market funds were not attractive as the returns on them were very low as well. At present, though, interest rates are high, and many economists expect them to rise further.2

This pushes up the income you can get from a money market fund, either from government debt or from cash, making them a more attractive choice.

Most money market funds attempt to beat a rate known as SONIA3, which is published by the Bank of England and calculated using the average of the interest rates that banks pay to borrow sterling overnight. At present this rate is well above four per cent, so the returns are more attractive.

Income is paid out to investors on a regular basis, but the exact timings may differ depending on the fund.

Are all money market funds the same?

There are many money market funds that individual investors can use, and they are all slightly different. There are two main categories, however, and you will need to know which type of money market fund you are investing in before looking any deeper.

The Investment Association classifies money market funds into two main types, either short term or standard. The shorter the time before the assets in the fund are due to be repaid, the less risky the fund is likely to be. Standard money market funds sometimes have slightly higher yields, representative of the fact they may be slightly higher risk.

Funds may distribute returns at different frequencies as well, and you can check this on the factsheets provided by the fund provider or with your financial adviser.

Are these funds as safe as cash?

Money market funds are not as safe as cash. Although the time until the investments in the fund are redeemed is short and the assets as low-risk as possible, this is not the same as low-risk cash. You do not have Financial Services Compensation Scheme protection in the same way as you do for cash, where you are guaranteed all of your money back up to £85,000 per institution if the bank fails.

Theoretically, in times of financial stress, money market funds could struggle to meet all investors’ demands if they wanted to take out all of their holding at once. The regulator says that these funds did come under pressure in the early days of the coronavirus pandemic. None were suspended, so everyone could get their money out, and there is a requirement for funds to maintain a certain level of liquidity, but this is a possibility.4

Why might I choose these funds instead of cash?

Despite these drawbacks, the funds do have some uses. Firstly they can be held in an ISA or SIPP, paying income to you in dividends which is then tax free. This means you can use them as part of an investment strategy for the long term, or park money in them if you are planning to invest it later but do not want to do so now. 

The returns are typically better than if you place cash into a cash ISA, and you do not have to transfer your funds between cash and stocks and shares products to use them.

However, they are unlikely to be a good choice for long-term investing as the returns are not designed to beat inflation.

What does it cost to hold these funds?

Unlike holding cash, you will pay charges to hold a money market fund, which can eat into your returns. You will need to consider the fees you are charged to hold money in a SIPP or ISA on a platform as well as fees on that particular fund and any fees for buying or selling funds. These fees will vary, so check with your financial adviser first.

What should I do if I think I want to buy a money market fund?

Money market funds can be purchased through your SIPP or ISA provider.

If you think a money market fund might work for you, you need to ensure you are comfortable with its individual investments and risk profile, as well as understanding the charges you will face and the alternatives to these types of fund.

This article does not constitute financial advice. You should speak to your financial adviser to determine whether these products are suitable for you. As with any investment, it is important to review it regularly to ensure it remains the right product for you.

Monday 26 June 2023