How Is Recent Volatility Affecting Money Market Funds?
This article reviews the unique features of money market funds and some of the concerns investors may have about this asset class.
Presented by Kevin M. Curley, II, CFP®:
A money market fund is not a bank account. It’s a type of mutual fund that invests in high-quality, short-term securities with a minimum level of risk. The dividends paid by money market funds are typically higher than bank interest rates. Investors benefit from a low level of risk and can usually withdraw funds quickly, an advantage known as “liquidity.” Because money market funds are offered by an investment fund company, rather than a bank, they are not guaranteed by the Federal Deposit Insurance Corporation (FDIC).
The Different Types of Money Market Funds
There are many types of money market funds, but they are primarily categorized as follows:
- Prime money funds that primarily invest in corporate and government-sponsored commercial paper (CP)
- Government money funds that primarily invest in cash, government securities, and other securities collateralized by cash or the U.S. government
- Treasury money funds that primarily invest in U.S. Treasury bills, bonds, and notes
- Tax-exempt money funds that primarily invest in municipal bonds
Some funds are intended for individual (or retail) investors, while others are intended for institutional investors.
Commercial Paper Concerns
CP is a form of short-term debt offered by large corporations. In essence, it provides credit lines that corporations rely on to pay for their short-term cash needs. The time frame to maturity for CP is typically 30 to 90 days. The buyers for CP include large corporations, banks, and prime money market funds. With a financial disruption, these buyers have been known to step back from the CP market to preserve their own cash liquidity. As a consequence, the borrowing rates for CP can spike, making it bad for the corporations that need to borrow money, but issues surrounding CP should have a limited impact on investors in money market funds.
Mutual Fund Risks
Of course, mutual funds come with risks. These include “breaking the buck,” liquidity fees, and redemption gates. These topics sound scary, so let’s put them into perspective.
Breaking the buck. This term refers to a situation in which the share price of a money market fund falls below its stated $1.00 net asset value (NAV). In general, a mutual fund’s NAV represents the total value of its assets minus liabilities as a per-share price on a specific date. With money market funds, the aim is to maintain a stable NAV of $1.00 per share. Excess earnings are distributed to investors by way of dividend payments.
For example, during the 2008 financial crisis, the NAV of a major money fund did drop below $1.00, thus breaking the buck. Since then, however, government regulations have been enacted to prevent another such occurrence. In particular, government funds and funds intended for individual investors are designed to maintain the $1.00 NAV. As for prime funds targeted to institutional investors, they can have a “floating” NAV that varies based on price fluctuations in the underlying holdings. This NAV is typically priced to the fifth decimal point (1.00001), so the variance tends to be very small.
Liquidity fees and redemption gates. Prime funds (for both individual and institutional investors) are permitted to impose liquidity fees and redemption gates. A liquidity fee is an extra fee that can be charged when shareholders withdraw funds. A redemption gate is a temporary restriction on withdrawing funds during times of extraordinary financial stress.
Create an Investor Action Plan
Let’s review a possible scenario that could help you develop an action plan. Let’s say you’re holding a prime money market fund because the dividends were higher than those offered by a government fund or the interest from a bank account. Due to economic events, you’re concerned about the risks of your shares dropping below $1.00 or not being able to withdraw your cash when you need it. You want to reduce your risks. To do so, you could consider moving your money from your prime fund to a government fund. The dividends from a government fund may be lower, but you won’t need to worry about share price, liquidity fees, or redemption gates. Lower dividends might be worth removing those items from your list of concerns.
In another scenario, you may want to entirely remove your savings from money market funds. In this case, you could move your funds into a bank sweep program. Commonwealth’s Bank Deposit Sweep Program (BDSP) places your cash in participating banks, thereby providing you with the benefit of FDIC insurance (subject to terms and conditions). In addition, interest income is typically generated. The difference in return between a government fund and the BDSP is about 60 basis points, or 0.60 percent.
Keeping Cash Management in Perspective
Seeing a drop in your investments is scary. But it’s wise to keep current market conditions in perspective and focus on well-established methods for cash management. Given the strong moves the federal government has made to support our economy, investing in money market funds remains a reasonable strategy—as long as you understand their unique features.
Managing volatility in your portfolio
A long-term perspective and diversified portfolio remain the best ways to take advantage of investment opportunities and hedge against risks, but staying the course is sometimes easier said than done, especially when we hold cognitive biases. To ensure that your retirement portfolio is positioned to benefit from future market upswings, keep these tips in mind:
- Resist the urge to sell. Even though your 401(k) may have lost some value over the past few weeks, it pays to stick to your plan. Allowing emotions to drive your decisions could mean missing out on potential gains when the market stabilizes.
- Don’t try to time the market. When you stray from your well-thought-out plan to chase higher returns, your 401(k) account performance may get worse, not better. We know that past performance does not guarantee future results and that, historically, when it comes to the various asset classes, there is no discernable pattern of winners and losers. Because there is no way to predict next month’s or next year’s winners, you have a better chance of doing well by holding a wide range of investments and maintaining a long-term focus.
- Keep contributing to your 401(k). Although you may feel uneasy looking at your account balance right now, this is not the time to stop contributing to your 401(k) or other retirement savings vehicles. Doing so could mean leaving valuable employer-matching contributions on the table. Further, if you reduce your contribution rate, you also reduce your ability to benefit from the magic of compound interest.
It’s understandable to be anxious about how market fluctuations will affect your retirement goals. A financial advisor can help you feel more confident in your long-term investment strategy by reviewing your account and ensuring that your assets are well diversified.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.
Kevin M. Curley, II is a financial advisor located at Global Wealth Advisors 100 Crescent Court, 7th Floor, Dallas, TX 75201. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA / SIPC, a Registered Investment Adviser. Financial planning services offered through Global Wealth Advisors are separate and unrelated to Commonwealth. He can be reached at (214) 613-6580 or at firstname.lastname@example.org.
Authored by Nick Follett, manager, fixed income, at Commonwealth Financial Network.®
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