Money market funds for better returns

Investors typically use money market funds as a substitute for bond funds. This article explains the characteristics of money market funds and shows why such funds are sub-optimal as part of the core portfolio. It then discusses the optimal uses of money market funds and also suggests how to choose such funds
Investors typically make sub-optimal use of money market funds. A case in point is a portfolio that we recently restructured, which had 25 per cent exposure to such funds. The investor claimed that he preferred such funds because it provided a relatively safe exposure to the bond markets.

This article explains money market funds and shows why they are sub-optimal substitute for bond funds. It then discusses optimal uses for such funds and also provides guidelines for choosing them.

Substitute for bond funds?
Money market funds such as Templeton Money Market Account invest in fixed-income securities with maturity of less than one year. Such securities include treasury bills, commercial papers, certificate of deposits and short-term fixed deposits; and call money market.

Most asset management firms offer “liquid funds” – Tata Liquid Fund, for instance – that invest in such money market instruments and bonds. SEBI in a recent circular has directed that such liquid funds should not make investments in money market instruments with maturity of more than 182 days. Further, from May 2009, such funds cannot make investments in instruments that have maturity of more than 91 days.

Now, money market funds are different from bond funds. A bond fund can invest in securities across the yield curve. This exposes the fund to high interest rate risk – the risk of bond prices declining in value due to increase in interest rates.

Money market funds are primarily exposed to reinvestment risk – the risk that moneys have to be reinvested at a lower rate due to decline in interest rate. On the positive side, bond funds generate interest income and capital appreciation.

Money market funds, however, generate only interest income. As capital appreciation is likely to be higher than interest income, substituting money market funds for bonds funds can drag down core portfolio’s risk-adjusted returns.

The net asset value of money market funds (with exposure in securities of not more than 182 days) is calculated on an accrual basis. That is, such funds essentially earn daily interest with no capital loss due to market risk. Such funds can, however, lose capital due to credit risk – for instance, defaults on commercial papers.

Enhanced cash returns
Money market funds are comparable with short-term fixed deposits with commercial banks. The former is more liquid, as unit-holders can withdraw at any time. In some cases, the initial lock-in period is 15 days.

Besides, an increase in interest rate is beneficial for money market funds as they can earn higher return on reinvestments. This and the exposure to higher interest-bearing instruments helps investors enhance their cash returns – returns that a portfolio earns on its cash and cash equivalents such as moneys in savings accounts.

The objective then should be to use money market funds for emergency cash requirement. A medical emergency is an example, as is the requirement for cash due to sudden loss of income.

An emergency fund should carry low capital risk and high liquidity. Money market funds can serve the purpose with enhanced cash returns.

These funds are also suitable for rebalancing satellite portfolio. This is a portfolio that is set up to generate excess returns over some benchmark index. An investor taking profit in her satellite portfolio can temporarily park the amount in a money market fund to enhance cash returns till she finds a suitable investment avenue.

Conclusion
Investors can use money market funds as a substitute for holding excess cash in the savings bank account.

But how should investors choose among peer funds? The recent credit crisis has dented the appetite for credit-risk instruments including commercial papers and structured obligations.

Treasury bills (issued by the government) and call market (mutual funds lending to commercial banks) carry low risk. It may be, hence, optimal to choose a fund that typically carries more exposure to T-bills and call market.

And importantly, have a relatively low management expense ratio.