Questions for cash funds

Investors in cash funds expect a return similar to what they might get at the building society. Emma Simon finds some may be in for a nasty surprise

This applies not only to bank and building society deposits, but also to cash funds, which have become increasingly popular with investors in recent years.

Investors use cash funds (also known as money market funds) for a variety of reasons. They are most commonly used to diversify an investment portfolio and to provide an alternative to a traditional building society account. But they are also widely used in Sipps and Isas, often as a ‘parking place’ for investors who are hoping to phase their money into volatile stock markets.

As most investment houses offer such funds, investors have a wide range to choose from. But these funds invest in a diverse range of investments, and can have very different risk/return profiles. This divergence has been exaggerated over the past year, as the credit crunch and the ongoing economic turbulence has caused problems for funds holding more volatile assets.

Most fund managers agree that such funds should aim to deliver a similar return to cash, and be a relatively low risk option for investors. But this does not mean that an investor’s capital is not at any risk.

Gavin Haynes, investment director at Whitechurch Securities says: “Our figures show that over the year to October 31, two-thirds of money market funds have provided a negative capital return, once investors have stripped out their income.

“The worst funds have produced a negative total return over 12 months, including income. Bottom of the table has been the Threadneedle UK Money Securities fund that has provided a negative total return of 7 per cent.”

He says that for investors who use these funds as an alternative to a deposit account this has come as a shock. “It is important to understand what instruments these funds use, as this will affect the return and the security they provide,” he says.

Peter Hicks, the head of IFA business at Fidelity International says cash funds can be split into two broad types: Treasury-style funds and investment money market funds.

Treasury-style funds invest largely in high-quality, liquid short-term securities. These include bank deposits, government securities, local authority bonds and some short-term high quality corporate bonds. These funds tend to hold short-dated securities, measured in weeks or months rather than years or decades. These are seen as less risky – not only will they give the fund more liquidity, but also reduce the fund’s sensitivity to interest rate movements.

In contrast, investment-style money market funds will invest in a wider range of securities, and usually seek to deliver an ‘enhanced’ return to investors. These funds invest in fixed income securities across the liquidity and quality spectrum, and can take on comparatively high levels of risk. Many of these funds will invest in asset-backed securities. For example some, though by no means all, of these funds will have invested in securities that were backed by US sub-prime mortgage, now known as ‘toxic debt’.

Many of these funds also invest in ‘floating rate notes’. These are predominantly issued by financial companies, and like corporate bonds pay a regular interest payment to the holder. The key difference is that the interest payment ‘floats’ at a specified level above a market interest rate, typically the London interbank offer rate (Libor – the rate at which banks lend money to each other). So as Libor goes up, the interest paid by a FRN moves up in line.

The size of the premium paid over Libor depends on the credit worthiness of the issuer. The more risky the issuer is deemed to be, the higher the premium they pay and vice versa. They are issued at a price of 100 and repaid at a price of 100 when they mature, so in other words, investors should get their money back if they hold them to maturity (provided the issuer has not gone bust). But the price can fluctuate during the life of the note.

Most advisers agree that the inclusion of such securities have caused problems for some money market funds. Much of this “commercial paper” has been downgraded by ratings agencies as a result of the credit crunch, which has caused the value of these securities – and these funds – to fall. In addition, some funds have invested in securities issued by banks and corporations – such as Lehman Brothers – that have subsequently gone into administration. This has had an effect on both the capital value and income paid by these funds.

Threadneedle, for example, which has been the worst performing fund in this sector over the past year, has approximately 33 per cent of its funds in these FRNs, while those that have performed best over the past year have little exposure to such assets.

A spokeswoman for Threadneedle says: “This fund is a money securities fund and as such carries a higher risk and reward profile than a straight cash fund.” She adds that prior to the credit crunch, the fund delivered strong performance, and when the economic situation improves then the value of the FRNs should rise again.

So should investors be looking at these funds at all in the current climate? Advisers point out that these funds can be useful in a number of situations. Brian Dennehy, managing director of Dennehy Weller & Co says: “These funds can be a useful way to protect capital, usually temporarily within some products, such as investment bonds or personal pensions.”

Many people also use them within their Sipp or Isa wrapper. Sipp investors often have access to only one cash account, which may not pay a particularly competitive rate, particularly with interest rates falling. Denney adds though: “Investors using such funds do need to try and understand what is going on beneath the bonnet, otherwise they could end up in a fund that is not suitable to their risk profile.”

But this can prove tricky. He adds: “Even if you are an investor or an IFA that understands the range of potential underlying instruments, getting accurate and up to date information on the current holdings is not easy in many cases. Believe me – we have tried!”

So how do you ensure you get a suitable fund? Andrew Wilson of Towry Law says: “The best cash funds will not necessarily be those with the highest yield, or those that were at the top of the performance charts in recent years. In fact those that previously hogged the top spots should be avoided in the current climate, especially if the returns promised are above Libor.”

In the past he says both advisers and clients got greedy with the headline yield figures, but the credit crunch has shown that there is no such thing as a free lunch. No one can offer a return materially above the risk free rate without taking some risk. This remains true with interest rates falling again. Cash funds offer higher yields than a building society account are necessarily also higher risk.

Instead, he recommends looking at funds that offer the greatest diversification of quality holdings. Dennehy adds that potential investors should look at returns over the past year or longer. If the performance has been fairly consistent then it is probably fine. “But if it hasn’t and it has wavered about then don’t buy it,” he says.

The graph above shows how this performance differs with four funds in this sector.

Finally, he suggests that Isa investors consider alternatives, such as Cofunds Cash Reserve, a simple deposit account. Sipp investors should also consider term deposits if they have larger sums they want to keep in cash. These often offer superior interest rates when compared to the Sipp’s default bank account.