Cash vehicle has become an expensive parking space The following article is based on the FAIR Report titled: Canadian Market Funds -- Zero Returns. Download the full study

March 11, 2010 - What could be safer and simpler than a money market fund? Long taken for granted as a safe and accessible parking spot for an investment portfolio’s cash, these funds have traditionally have been seen as neither a place to get rich - or to lose money. With interest rates at historic lows in recent years, the former has never been more true. But the latter assumption is not longer correct.

The average Canadian money market fund yielded a negligible 0.02% during the second half of 2009. But more disturbing is that one-quarter of these funds actually produced negative returns during that period, thanks to their management expense ratios - the fees charged for administration. Money market funds' MERs are far lower than for equity and other types of funds - but even at a relatively low 1% or less, it doesn't take much to wipe out a rate of return in today's low interest rate environment.

The good news is most of the money losers were small insurance-industry segregated funds, which charge higher annual management fees in exchange for principal protection and death guarantees. And none of the biggest funds by assets were in the red.

MMF returns lag inflation

Performance isn't a major issue because money usually is held in these funds only temporarily, until the unitholder decides how to reinvest. But the fact remains that a 0.02% return over six months simply isn’t enough because, after inflation, you're losing ground.

Thus the opportunity cost of not seeking a better cash return has become too great. It costs Canadians an estimated $300 million to $500 million a year overall in interest income by not shifting their money out of money market funds to higher yielding premium savings accounts at financial institutions.

For example, as of early this year, most premium savings accounts at financial institutions were paying significantly more than the average money market fund - 0.75% and 1.2% per annum, and in some cases in excess of 2%.

But there are other factors to consider before abandoning a money market fund for a supposedly greener cash pasture. Can the typical investor do much better with his cash? And, if so, is it purely a matter of finding a higher rate of interest? What about the administrative cost of moving the money elsewhere, and the loss of convenience if you intend to eventually reinvest the money within the same fund family or brokerage account?

Different types of money market funds

Before considering the alternatives, it is important to understand how a money market fund works. There are several types of these funds:

• Traditional money market funds can hold federal and provincial treasury bills as well as bonds issued by those governments and corporations with high credit ratings. They also can hold bank-backed commercial paper and floating-rate notes. Interest is accumulated daily and paid to unitholders monthly, usually automatically in the form of new units in the fund. They are allowed to hold securities with maturities of up to one year. Most funds' prices (net asset values) are fixed at $10 and the rate of return is determined by the interest payout. Most traditional funds are denominated in Canadian dollars, but a handful of funds are in U.S. dollars.
• Treasury money market funds are similar to traditional funds, but are allowed to hold only federal and provincial treasury bills. Since these are more conservative than traditional funds, their yields tend to be slightly lower.
• Segregated money market funds are similar in content to money market mutual funds but they may hold securities with maturities of up to 25 months. They are sold by insurance agents as "individual variable insurance contracts" and offer a guarantee of capital at maturity, typically 75% to 100% of the investment principal. They are sponsored by insurance companies, and in some cases are sold through mutual find companies. Some offer a death guarantee, an ability to reset the guarantee amount at various intervals, guaranteed minimum withdrawals, and other benefits. As a result, their management expense ratios often are substantially higher than for other money market funds. In addition, they must set their prices to market value, as opposed to the fixed $10 set by most of their mutual fund counterparts.

Other cash investments

So what are the alternatives to money market funds, and what makes them a potentially more attractive place to stash your cash? In a nutshell, most of them provide a better return and often are guaranteed by the financial institution and/or government deposit insurance.

• Basic savings accounts: These pay little or no interest. Some accounts pay a reasonable rate on higher balances, either by virtue of a high minimum investment or through a tier system that pays progressively higher rates depending on the size of the balance on deposit. (For example, a tiered savings account might pay no interest if there is less than $5,000 in the account, but 0.05% of the balance is between $5,000 and $10,000, and so on up to 0.5% if the balance is $250,000 or greater.) During the past four years, the difference between interest paid by savings accounts and money market fund yields has ranged from zero to roughly a quarter of a percentage point.
• Premium savings accounts: This segment of the deposit market is very competitive and these accounts have provided returns superior to money market funds in recent years. These accounts usually have high minimum deposit requirements, often $1,000 and in some cases $25,000 or even higher. Premium accounts on average have earned a full percentage point or more on an annual basis in recent years.
• Term deposits and GICs: Short term deposits tend to pay interest similar to that of premium savings accounts and require minimum investments. Non-redeemable deposits (those that are locked in until the maturity date) pay higher rates than redeemable deposits. Longer term guaranteed investment certificates usually provide better returns - but in many cases your money is non-redeemable. So the decision to use a term deposit or GIC as a money market fund alternative depends on whether you can live without having access to the cash for the length of a non-redeemable term.
  
  Note that savings accounts, term deposits and GICs at banking institutions are insured up to $100,000 per institution by the federal government through the Canada Deposit Insurance Corporation.
• Short-term fixed income funds: If you want to keep cash within a fund structure, these are the next best thing to money market funds because they are conservative and accessible. They also tend to produce the best return among money market fund alternatives. Short-term fixed income funds invest mostly in government or corporate bonds, mortgages, commercial paper and other short-term debt instruments. Their holdings typically have longer maturities, of up to 3.5 years, compared to 90 days for money market funds. Unlike money market funds, there are no legalities governing how they must invest; they are simply grouped according to a classification set by the firms that track fund information. Unlike money market mutual funds, they have floating net asset values. However, they are riskier because they are more exposed to interest-rate fluctuations and credit-rating changes, and there is some risk of capital loss.

How money market fund returns compare

So why stick with a money market fund?

While savings accounts and term deposits/GICs provide a better return than money market funds, there are valid reasons to keep cash in a money market fund. Here are three:

• Convenience: In most cases a money market fund most often is used as the cash portion of a portfolio containing exclusively mutual funds (or segregated funds). It provides a convenient place to put the proceeds from the sale of units of an equity fund until a new equity investment is selected - or if equity market conditions are unfavourable, to leave there until a better time to reinvest.
• Tax deferral: In the case of funds held within a corporate class - in which assets are held within a tax-deferred "fund of funds" allowing money to be moved among asset types without triggering capital gains or losses - tax is only payable on transactions when assets are removed from the corporate umbrella. Thus a money market component of a corporate class investment is the only tax-deferred cash alternative.
• Avoid fees and penalties: If you purchased money market fund units on a deferred sales charge basis, depending on how long you have been in the fund, you may face early redemption fees - in some cases as high as 7%. A money market fund held as an RRSP investment might be expensive to leave for an alternative cash investment because you could face annual trustee fees. In addition, there can be delays and excessive paperwork involved. And departing a segregated money market fund can mean penalty charges and, of course, loss of the capital guarantee.

About FAIR
FAIR, the Canadian Foundation for the Advancement of Investor Rights, is an independent national non-profit agency.

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