Inflows into money market funds have soared in the last year as investors seek higher returns on their cash.
With yields above 5 per cent, investors are turning to cash-like instruments to protect from inflation eating into their cash.
May savers will put their cash in easy-access savings accounts instead, which offer similar returns.
Money market funds have become popular among investors looking to shield their cash for a short time
But money market funds have emerged as an alternative for investors to put their cash for a short time.
With better returns than savings accounts, should you consider dipping your toe into money market fund investments? And how could the prospect of a rate cut affect returns?
What are money market funds?
Money market funds, often described as cash bonds, invest in a selection of investments considered the safest available.
The Investment Association categories money market funds into short-term and standard-term funds.
Short-term funds tend to be lower risk, while standard funds tend to deliver higher returns but have slightly longer maturity dates.
In terms of what they actually invest in, it is usually cash and cash-like instruments where yields are tied to interest rates.
They also invest in short-term debt issued by governments and companies unlikely to default.
Their yields have become more competitive as interest rates have climbed, rising to an average of 4.66 per cent in 2023.
Their relatively low-risk profile has increased demand too. Last year, money market funds had their best year on record, with inflows exceeding the last eight years combined, according to Calastone’s Fund Flow index.
Is it a better option than a savings account?
Money market funds are considered relatively low-risk but, like any investment, their value could still fall.
While this is uncommon, it is worth considering if you are weighing up money market funds versus a savings account.
Rates on savings accounts are still pretty generous – the best easy-access savings account is currently offering 3.12 per cent, according to Moneyfacts, while an easy-access Isa rate is 3.31 per cent.
You can check the best deals in our savings tables.
So why are investors opting for money market funds rather than putting their cash in a savings account?
The two are very different. Cash funds are primarily used for a short period, rather than a long-term investment.
Investors often park their money there if they don’t want to get out of the stock market altogether.
Laith Khalaf, head of investment analysis at AJ Bell says: ‘For those who want to earn a return on cash they’re waiting to invest, and investors who need to hold some cash-like assets in their portfolio, such as drawdown investors, money market funds have become increasingly popular.’
Keeping cash in a money market fund, within your stocks and shares Isa, also makes it much easier to switch between funds.
‘If you want to switch from one cash account to another because rates have changed, this usually involves moving banks with all the hassle that entails,’ Khalaf adds.
‘Money market funds are slightly riskier than cash accounts, but they do have long records of stable and secure valuations, with extremely low levels of volatility.’
That said, there is a risk that money market funds could face liquidity if too many investors rush to take their money out at once.
Darius McDermott, managing director of FundCalibre says that cash funds are ‘not a bad, temporary option’ for people who like to switch in and out of funds.
‘For most people, it’s going to be simpler to stick with an easy-access savings account. You’re unlikely to get much more return from money market funds than the current base rate, and investors should take into consideration the fees that come with them (usually around 25 basis points).’
Jason Hollands, managing director of Bestinvest, says he has seen increased interest in money market funds on the platform, ‘though it has been an uptick rather than a torrent’.
He adds: ‘However, in the main, most clients wanting a short-term home for parking their subscriptions opt to hold cash, as the current interest rate paid by our custodian is an attractive 4.45 per cent and no account fees are levied on this.’
Other platforms also offer interest on uninvested cash held in an Isa, although this is usually much lower than a savings account.
AJ Bell offers 2.52 per cent on up to £10,000 in an Isa, which rises to 3.55 per cent above £100,000, while Hargreaves Lansdown offers 2.2 per cent.
Interactive Investor offers 2 per cent on the first £10,000, rising to 2.75 per cent between £10,000.01 and £100,000 and 3.75 per cent between £100,000.01 and £1million.
Will cash funds be attractive after rate cuts?
The yields on money market funds are affected by interest rate movements and expected changes.
While getting a good return is not the only reason for holding money market funds, some investors might reconsider their portfolio weighting.
‘This means that if rates fell in the second half of the year, money market yields would also fall. If rates rise or stay still, then yields will stay high, however,’ says Sam Benstead, fixed income lead at Interactive Investor.
‘But with the Bank of England only likely to cut rates one or two times this year, the impact on yields should be relatively small. If inflation keeps falling, then real (inflation-adjusted) yields may actually rise even if headline yields drop.’
McDermott is less convinced, and says: ‘If rate cuts eventually come through you probably don’t want to be in cash,’ because returns will go down.
Instead, he advises investors to look into longer-dated bonds, which are locked in at higher returns for longer, or real estate investment trusts (REITs).
‘If you have a higher risk appetite, consider UK small caps. For REIT exposure, the TR Property Investment Trust is a strong option, while for UK small caps we currently favour IFSL Marlborough UK Micro Cap Growth and Liontrust UK Micro Cap.’