Should you join the dash for safe haven funds that pay 4%?

As storms rage in the financial markets, more and more investors are looking for safe havens to catch their breath. Many are being lashed by the effects of soaring inflation, rising interest rates around the world – and the threat of another global banking crisis.

Add to that the prospect of further volatility from the war in Ukraine and speculation about conflict between China and the West, and it’s understandable that many investors are nervous – even though financial markets are proving remarkably resilient.

While there have been worrying flare-ups, such as last week’s collapse of US bank First Republic, which was sold to JP Morgan Chase, they have so far been resolved without triggering a full-blown global crisis.

Money market funds are emerging as a popular place for investors to dock for a short while and wait for the sky to clear. These are funds that invest only in the safest assets, such as cash and bonds issued by governments and companies.

Investment platform Interactive Investor has seen a 40 percent increase in money market funds owned by its clients this year. Rival Hargreaves Lansdown saw a 2,000 percent increase in the year to April.

But money market funds are far from a perfect solution. Experts warn that they are not necessarily as safe as they seem at first glance. Moreover, the returns barely match those of a well-paid savings account.

So should you join the jitters of investors crowding into these funds – or should you stay clear? Wealth & Personal Finance investigates.

How do these funds invest your money?

Money market funds invest your money in a selection of investments that are considered to be the safest. They usually consist mainly of bonds issued by robust governments and companies that are very unlikely to default.

Some money market funds add an extra layer of protection. These so-called short-term funds only invest in bonds that will expire very soon. The logic is that the shorter you have to wait for the bond debt to be repaid to you, the lower the risk of something going wrong in the meantime and jeopardizing your money.

Money market funds usually distribute income in the form of dividends. Some currently yield just over one percent in dividend income, while the highest paying ones offer about four percent.

Would a savings account be better?

As interest rates on savings continue to rise, several high-paying accounts offer a higher rate than the income available on money market funds.

OakNorth Bank, for example, pays 4.86 percent into a one-year fixed-rate account. Chip offers 3.71 percent in an easily accessible bill. Savings accounts also have the advantage over investments of FSCS protection, a government-backed protection of savings up to £85,000.

So why do some investors choose money market funds instead of simply putting their money in a savings account?

Money market funds are not comparable to a long term fixed rate account. This is because they should only be a short-term place to park some of your investments. Second, nervous investors often don’t want to get out of the stock market altogether, which would entail transferring money to a savings account. They just want a safer option for a short period of time.

Investors who want to keep their money in their Individual Savings Account (ISA) or Self-Invested Personal Pension (SIPP) do not have access to the best savings rates. Investment platforms allow clients to hold cash within their ISAS and SIPPs. But their rates are less attractive.

For example, investment platform AJ Bell pays 2 percent interest on cash balances in Sipps up to £10,000 and 2.75 percent on balances above that amount. Hargreaves Lansdown pays just 1.25 per cent on cash in an Isa with balances up to £10,000, gradually increasing to 2.25 per cent on balances of £100,000 or more.

Is a money market fund right for you?

If you’re considering moving some of your investments into a money market fund, make sure you’re doing it for the right reasons.

Episodes of turbulence in the financial markets are normal and all part of investing. There are often periods of volatility, but a diversified portfolio of company stocks and bonds tends to increase in value over the long term.

If you take your money out of the market during tough times, you risk missing out on later recoveries.

Even amid the current turmoil, investors in corporate stocks have enjoyed good returns. The MSCI World, an index of the world’s largest companies, is up more than ten percent this year. The FTSE 100 index of the largest UK companies is up 3%.

So if you don’t need your money for at least five to ten years – or rather much longer – you may not need to look for safety.

If worrying about your investments keeps you awake at night, the short-term protection offered by a money market fund may not be enough. It may be worth looking at your portfolio as a whole and considering whether you need to lower your risk profile by moving to a range of safer assets.

If you plan to spend your investments within five years, you’re probably better off keeping your money in cash than investing at all.

Darius McDermott, managing director of investment platform Chelsea Financial Services, says that even if you use them, you should only put a small portion of your portfolio in money market funds.

“You could use them on an investment platform for short-term tactical asset allocation,” he says. “If you’re nervous about markets, for example, you could move 10 percent into money market funds as a short-term stay.

“But check the rates the platforms offer on real money rather than money market funds – sometimes that might be a better option.”

Be careful not to invest in money market funds for too long. The relatively low income they provide makes them particularly vulnerable to the ravages of inflation.

The consumer price index of inflation is still raging in double digits at 10.1 percent.

How safe are they against turbulence?

Although money market funds are low risk, they are far from completely safe. First, if a large number of investors tried to pull their money out of these funds all at once, their value could fall and they could become harder to sell.

The brutal truth is that DIY investors are just minnows when it comes to selling money market funds.

The vast majority of these funds are held by large investment and pension funds, financial institutions and local governments. Should some of these investment giants suddenly go to exit, it would very quickly create big waves among all investors.

Money market funds came under severe pressure in March 2020, during the sell-off in the financial markets caused by the initial Covid-19 lockdowns.

Anxious investors rushed to move from these funds to cash, and some money market funds struggled to match buyers and sellers at the level required by law.

Fortunately, no funds had to be suspended and disaster was averted. But it showed that money market funds are far from perfect.

“Everything works out 99.9 percent of the time, but we’ve seen that money market funds are not exempt from stress,” says McDermott. “Why bother with the extra risk?”

The investment returns of these funds are also far from certain. They have risen in recent months thanks to rising interest rates in the US, UK, Europe and around the world.

However, if interest rates start to reverse – especially in the US – yields could fall.

Jason Hollands, managing director at investment platform Bestinvest, adds: “If the US slips into recession at the end of this year or next year, as some economists predict, and if inflation continues to fall, the US Federal Reserve may well go backwards. . and start lowering rates again.”

Choose a fund that suits you

All money market funds are designed to be low risk, but some are more than others.

L&G Cash Trust is one of the most popular and pays one of the higher rates at 3.9 percent. However, McDermott says the fund is “too concentrated for my taste” as it invests a quarter of its fund in investments from three institutions; Rabobank, Nationwide Building Society and First Abu Dhabi Bank.

Another popular fund, the Abrdn Sterling Money Market Fund, has a more secure portfolio held primarily in bank accounts. However, it yields only 1.22 percent. Mike Stimpson, a partner at asset manager Saltus, suggests that a larger fund may be safer than a smaller fund. “By being invested in a larger pool of capital, you may have a greater margin of safety than in a smaller fund,” he says.

Stimpson adds that if a money market fund outperforms its peers, it may indicate that it is taking on more risk. If you’re using such a fund to avoid risk, you may not think it’s worth chasing the outrageous returns.

Investors should also consider fees, as they can hurt your returns. “Money market funds are usually very cost competitive – with an ongoing charge of about 0.15 percent,” adds Stimpson. But ensuring that there are no high transaction costs remains important.’