Saturday, April 26, 2008

What is a money market fund?

It is a type of unit trust fund. Where general equity unit trust funds buy shares on the stock market and pay you a largely dividend income, money market funds are invested in money market instruments and pay you an interest income. It is much the same as having your money on call at the bank, except you earn a higher interest rate.

This is because the money market fund pools your money, let's say 20,000, with other people's money to total, say, 1-million, and is thus able to command the higher interest rates available in the wholesale money market.

The funds' other main advantage to smaller investors is that, unlike bank fixed deposits, you are able to withdraw your money on demand.

Money market funds are invested in interest-earning instruments such as bankers’ acceptances, treasury bills and NCDs. These may sound like gobbledegook, but broadly they are the financial instruments used by banks, government, and local municipalities to borrow money.

As an individual investor you won't have access to the wholesale market unless you have over 1-million to spend.

Money market instruments are all short term; the funds have been lent to the government or institution for less than a year.

The average term of all instruments held by the fund has to be less than 91 days.

How does money market fund work?
The price of each unit of the fund is 1, and this is constant. Where you make your money is on the interest income paid out to you.

The rate quoted in newspapers is the average interest rate the fund has paid out over the last seven days - the purpose of this calculation is to smooth out short-term fluctuations to give you a better idea of the fund's performance. Interest is calculated on a daily basis, but all payments are made at the end of each month.

It is important to note that the rate quoted in the paper can be misleading as it may make you think you are earning more than you are. The rate quoted is an effective rate, which means you only earn this if your money is on deposit for the entire year with all interest being reinvested and therefore compounded - you will not be earning this rate if you take your money out sooner or if you withdraw your income.

Please pay close attention to its nominal rate as this is the rate you should use to compare with what the banks are offering. A nominal rate is the amount you actually earn each month.

There are costs for the investor to pay. The funds offer either a low or no entry fee, and a relatively low annual cost.

The quoted interest rates on funds are stated net of the annual fee.