So here’s a hypothetical scenario:
Oh hey there. Yes, I put all my savings into a money market fund. I think all those other investing options are really unsafe, and at least money market funds beat inflation.
Here’s a response:
And I know this because Money Market Fund brochures always start with something along the lines of:
“The Money Market Fund is suitable for you if need a short-term investment account and/or are highly risk averse but seek returns higher than bank deposits.”
That is: you are only really meant to put savings in a Money Market Fund while you are in the process of liquidating one asset in order to buy another (for example, you’ve just sold your house, and you’re waiting to sign papers before you pay the deposit on a new house). In those situations, you don’t want to risk the money too much, so you lock it into something reasonably safe.
But unless you are rendered near catatonic by the thought of risk, what you don’t do is put all your savings into Money Market Funds just because you feel like they’re really safe.
The trouble is: this is the kind of safety that you have to pay for. Basically a money market fund is a bit like an insurance policy, where you pay a premium for the safety (although, as with an insurance premium, you take the risk that the insurer might go bankrupt).
So what do I mean by that?
Well, the objective of a money market fund is twofold:
- (Mainly) to make sure that your capital stays intact; and
- To earn interest that covers you for inflation.
Now as I mention in my precursor post to this one on inflation (Not All Inflation Is Created Equal), there are some issues with beating ‘headline’ inflation.
The Issue With Headline Inflation
Headline inflation is just an average of all the inflations. But if you’re the kind of person that can have this conversation about money market funds, then you’re the kind of person whose consumption patterns are on the wrong side of the average consumer basket (ie. your personal day-to-day increases in your cost of living are almost certainly higher than headline inflation).
- Headline inflation between July 2015 and July 2016 was 6.1%.
- But inflationary increases for food items like “Vegetables” and “Oils and Fats” over the same period floated somewhere between 15% and 21%.
- If you’re the kind of person that goes on holiday overseas in December/January, then your annual holiday over the 2015/2016 Festive Period was about 38% more expensive in Rand terms than it was the year before.
I mean, I guess that could sound a bit elitist. But practically speaking though, I stand by the earlier point: if you’re reading a blog post about money market funds, then you’re probably not the average consumer.
And if you’re earning a 7% return on your cash, but your personal inflation rate is sitting somewhere in the 10% range, then that extra 3% is already a kind of ‘insurance premium’ for capital preservation.
But that is not the only part of the story.
You always need to look at the tax. And unfortunately, interest income is taxable.
How it works in the SA tax code (as of the 2016/2017 Tax Year):
- If you’re under the age of 65, your first R23,800 worth of interest is exempt from tax.
- If you’re over the age of 65, your first R34,500 worth of interest is exempt from tax.
- Thereafter, you’re taxed at your marginal tax rate.
So to show how that plays out, I’ve made some graphs with the following assumptions:
- You invest a lumpsum for a year.
- You’ve chosen the Allan Gray Money Market Fund, which repeats its 1-year-to-date performance over the next 12 months (getting you a Gross Return of 7.1%).
- Inflation remains constant at 6.1% over the next 12 months.
- If you’re earning more interest than the exemption thresholds, then you’re going to be paying tax in the top tier at 41% (because, well, that’s the most likely scenario).
There are two graphs (one for taxpayers under the age of 65, and one for taxpayers over the age of 65). Here is what the effective returns will look like:
What that means:
- If you’re under the age of 65, once you’ve got more than about R500,000 in a money market fund, you risk earning less than inflation after you’ve finished paying off tax on the interest earned.
- And if you’re over the age of 65, that threshold is somewhere around the R700,000 mark.
So if you’re the type of person that throws all their savings into money market funds:
- Not only do you risk paying an ‘inflation’ premium;
- You also risk earning less than headline inflation once you’re done paying tax.
And that’s the ‘safety’ insurance premium.
Short Term, Though
But have a look at how those thresholds change once you start looking at this as a once-off, short-term strategy. If you’re only in the Money Market Fund for 6 months:
Suddenly, those thresholds are doubling up on themselves.
Final Thoughts On Risk
It’s important not to let loss aversion get the best of us. Money Market Funds have a purpose – and that purpose is not long-term investment.
Yes, other things are sometimes riskier. But it’s okay to take risks – we take them all the time. And sometimes, it’s safer to take the apparently-riskier path, because at the end of the day, the risk of loss is more guaranteed in the ‘safer’ option.
In the real world, investing long-term in money market funds is a bit like always choosing to drive down to Cape Town because you’re afraid of dying in a plane crash. Yes, people die in plane crashes. But relatively speaking, a lot more people die in car crashes.
Just because you’re used to driving cars, or ‘savings accounts’ that earn interest, doesn’t mean that they’re necessarily the safest way to go.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.
Kosta August 29, 2016 at 09:10
Ah man I am loving this series on inflation 🙂
Taxable interest implications aside, this point hit home:
“And if you’re earning a 7% return on your cash, but your personal inflation rate is sitting somewhere in the 10% range, then that extra 3% is already a kind of ‘insurance premium’ for capital preservation.”Reply
Matt August 29, 2016 at 17:04
Awesome post, thanks.
I am fascinated by the thought of MM funds as part of a large shadow banking system, effectively borrowing at daily liquidity from investors and investing in instruments up to 364 days. Not being guaranteed, it will be interesting to see whether a big credit or liquidity event will one day have an impact of the “safety” of these funds. (Not saying I wouldn’t use them for short term investments, where applicable, just could be an interesting topic) 🙂Reply
Kosta August 30, 2016 at 09:35
Matt, spot on mate.
It makes one question the benefit of leaving short-term cash in a Money Market fund (like Allan Gray’s for example) versus the “Money Market” savings accounts offered by the banks.
For example, Allan Gray’s MM fund currently yields 7.7%, where as FNB’s “Money Maximiser” yields 7.3%.
Deposits into FNB’s Money Maximiser account are guaranteed by FNB, whereas Allan Gray have this interesting fine print in their Money Market fund fact sheet:
“While capital losses are unlikely, they can occur if, for example, one of the issuers of an instrument defaults. In this event investors may lose some of their capital. To maintain a constant price of 100 cents per unit, investors’ unit holdings will be reduced to the extent of such losses. Excessive withdrawals from the Fund may place it under liquidity pressure; if this happens withdrawals may be ring-fenced and managed over a period of time.”
Makes you question whether that extra 0.4% is really worth it, especially given the self-imposed upper limit on these funds in lieu of the charts shared in the article above. Personally I’d rather sacrifice the 0.4% and go with FNB’s account. Added benefit: instant access.Reply
Matt August 30, 2016 at 11:09
Exactly. Most Corporates now also use MM Funds for their short term cash. And that also has a knock on effect for the banks who require that cash to on-lend to clients. This then leads FNB and the other banks to increase their own lending rates to match those MM funds rates, which in turn leads to higher lending rates for clients….
As I said before I still use MM funds and I would recommend them to be used for the right purpose, it will just be interesting to see if a “MM fund run” would cause some havoc in the financial systemReply
The Editor August 31, 2016 at 17:11
Some CIS in MM instrument have had unit prices below R1.00 previously. Generally, the UT ManCo steps in and pumps up the B/S of the Fund. There was concern that this might happen when African Bank was topical as it offered higher yields and many MM UT’s had exposure to their paper.Reply
Timothy Van Blerck September 5, 2016 at 11:50
What wot the author recommend as the next low risk asset category to invest in once interest tax exemption is used up?Reply