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Money Market Investment Risks

  01/08/10 07:14, by Len, Categories: Financial Management, Investment Management, Money Markets

Source: Article by Ian Liddle and Andrew Lapping of Allan Gray

Your money is perfectly safe in a money market fund, right? Wrong!

Risk: The possibility that something unpleasant will happen / the possibility of meeting danger or suffering harm or loss (Oxford English Dictionary).

We expect that all readers of this article have come to accept by now that Santa did not squeeze down our chimneys this festive season and that the Easter Bunny will not be knocking on our doors in April. But many of us are still struggling to wean ourselves from a belief in the most fantastical and mythical creature of all: a risk-free investment. So we will say it now: there is no such thing as a risk-free investment.

Understand the risks

The cataclysmic events of 2008 have surprised many of us, but none more than the investor who did not realise the full extent, or even the very existence, of the risk to which he or she was exposed before 'something unpleasant' happened. We want you to entrust your savings to our care with full knowledge of the risks to which you are exposing yourselves. We strive to communicate clearly and effectively to minimise the risk of you suffering a nasty surprise one day.

The purpose of this article is to reinforce this message (which is consistently conveyed in our more formal documentation such as fund fact sheets, unit trust deeds and mandates): Allan Gray does not guarantee any of the funds which it manages in any way whatsoever. Investors in all funds and portfolios under our management are exposed to risk. The nature of this risk will vary dramatically depending on the nature of the investment mandate given to us. Nonetheless, this message applies equally to all types of portfolios which we manage, including the Allan Gray Money Market Fund.

One needs look no further than the 2008 annual investment performance numbers for our suite of unit trusts to see that the Allan Gray Money Market Fund did a good job last year of protecting investors in the Fund from the ravages of falling stock markets — not too surprisingly since its mandate does not allow stock market investments. But that does not mean that the Money Market Fund is a risk-free investment.

On the contrary, investors in the Money Market Fund are exposed to a number of risks which can result in real (and, in extreme situations, even nominal) capital losses. The rest of this article discusses the three major risks to which investors in the Money Market Fund are exposed:

1. Negative real interest rates

2. Credit risk

3. Liquidity risk

Negative real interest rates: the decline of purchasing power

If the rate of inflation exceeds after-tax interest rates, then the spending power of an investor’s capital in the Money Market Fund will decline over time even if he or she re-invests all of the after-tax income distributed from the Fund. Some investors may well say that they prefer to go backwards slowly and predictably rather than very abruptly as happened to equity market investors in 2008. However, most investors probably do not want the purchasing power of their capital to go backwards indefinitely.

Will history repeat itself?

South African savers have been somewhat spoiled since the mid-1990s when real after-tax interest rates for the man-in-the-street turned positive (we have simplified the analysis by using a consistent tax rate of 25 percent). What is the chance of real interest rates being negative for an extended period? It's quite high, if history repeats itself. With the exception of a few short-term blips, real interest rates in South Africa were negative from 1971 to 1995.

Licensed to print money?

Governments around the world are going to be hard-pressed to deliver on their bail-out and stimulus promises and the temptation will certainly be there for politicians to 'print money' and/or engineer negative real interest rates.

To use an extreme example, if you had had the misfortune of investing in a money market fund in Zimbabwe a few years back, you would not have lost a single Zimbabwean dollar, but you would have lost the entire spending power or real value of your investment.

The Allan Gray Money Market Fund provides great protection from falling stock markets, but it cannot provide any protection from the erosion of your real capital should our country’s policymakers choose to administer negative real interest rates (or print truckloads of money in an extreme case). However, other funds in our suite such as the Allan Gray Equity Fund, Balanced Fund and Stable Fund may provide some protection from this risk to the extent that they invest in real assets, such as equities, as opposed to monetary assets.

Credit risk

The Allan Gray Money Market Fund invests in debt instruments (or 'IOUs') which oblige the issuer of the IOU to repay a fixed money amount on a specified date within the next year. If the issuer were to go 'bankrupt' and default (in other words not be able to pay the full amount due when it is due) the Fund and its investors would bear a loss.

One way in which we try to address credit risk is to invest the Fund in a diversified portfolio of debt instruments issued by a range of issuers, so that any potential losses arising from the default of any one issuer will be constrained to a limited portion of the Fund’s portfolio. Indeed, the regulations governing the Fund restrict exposures to different types of issuers to limits which enforce some diversification of the Fund’s holdings.

Of course, the benefits of diversification will be tempered if the default of one issuer sets off further defaults by other issuers in a domino-effect crisis. In the event of a systemic crisis like this, governments around the world have typically stepped in to shore up and stabilise the financial system (as has happened in the US and elsewhere in 2008).

Obviously, some issuers are more at risk of defaulting than others. Typically, these 'riskier' issuers have to pay a higher interest rate on their debt to compensate investors for the extra risk. Assessing whether or not this higher interest rate is sufficient compensation for the extra risk is inherently subjective and it depends on one’s own assessment of the likelihood of uncertain future events. There is no way to assess the right or wrong answer at the time of investment — investors in any debt instrument need to exercise their own judgement as to whether there is sufficient potential reward for the credit risk.

When managing the Money Market Fund, we have a very low risk tolerance as we are mindful that the objectives of capital preservation and liquidity are paramount for investors in the Fund. We believe the Fund is very conservatively positioned, with 27.4 percent of the Fund invested in government or parastatal securities, 15.7 percent in corporate paper backed by multinationals with the same or higher credit ratings than the South African government and 56.9 percent on deposit with South Africa’s major banks.

Extreme circumstances can heighten liquidity risk

In most circumstances investors in the Money Market Fund can give one day’s notice of their intent to withdraw all their funds, but we do not invest the entire Fund on call deposit as we think it unlikely that all the Fund’s investors would suddenly want to withdraw all their funds on the same day. By investing in longer-dated paper we can improve the yield earned by the Fund and its investors.

However, in extreme circumstances (such as were experienced in the US money markets in 2008), withdrawals can be unexpectedly large and this may force the Money Market Fund to sell its longer-dated paper in order to fund the withdrawals. If this paper is sold at a loss (as there may be other money market funds all trying to sell the same paper at the same time), then that loss will be borne by the Fund and its investors.

How we alleviate liquidity risk

There are several ways in which we attempt to mitigate liquidity risk:

* Maintain a buffer

First, we structure the Fund’s investments so that there is a relatively smooth flow of maturities for funding withdrawals in the ordinary course. We also maintain a buffer on call deposit to fund a certain level of unusual withdrawals.

* There is a plan in place to fund withdrawals

Secondly, under more extreme circumstances, we have the right to borrow up to 10 percent of the assets of the portfolio in order to fund withdrawals and have banking facilities in place should this be necessary. This allows us to buy some time to realise assets and reduces the risk of the Fund being forced to sell investments at short notice which would prejudice the remaining unit holders.

* 'Ring fencing' protects remaining investors from large withdrawals

Finally, we have the right to 'ring fence' large withdrawals. What this means is that should the Fund experience net withdrawals equal to more than five percent of its assets on any one day, we are allowed to set aside a representative five percent 'slice' of the portfolio and realise the investments in an orderly fashion over a period of time and pay the withdrawing unit holders out of the proceeds. This means that withdrawing investors may wait for more than the customary one day to receive their cash, but those investors remaining in the Fund are protected from the consequences of a fire-sale.

Disclaimer: Understand your investment risks

This article is not an attempt to either encourage or discourage investors from investing in our Money Market Fund. But, after a year in which the Allan Gray Money Market Fund has been one of the top-performing funds in our unit trust suite, we thought it appropriate to emphasise that, although the Fund does avoid stock market risk, it carries its own unique set of risks which in an extreme scenario could result in losses for investors in the Fund. The Allan Gray Money Market Fund is not a risk-free investment.

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