Cautious investors have been fleeing equities for the security of cash in recent months. But even some cash investments have failed to provide the safe haven that investors might have hoped for.

Investments promoting themselves as cash-based funds have been taking exposure to riskier assets such as low-grade corporate debt and other unreliable credit facilities, and have run into difficulties in recent months.

The result is that many funds aiming to beat cash rates have returned significantly less than is available through high-street bank accounts. Some funds have even fallen into negative returns.

So, while the concept of keeping a proportion of a portfolio in cash sounds straightforward, it is now essential that investors make the right decisions.

There are two main types of cash funds: traditional money market funds, which invest in deposit accounts as well as other high quality short-term lending facilities; and enhanced” or “strategic” funds, which take more credit risk with a view to generating higher returns.

A number of enhanced funds have sprung up for retail investors over the past couple of years, from managers including Threadneedle, Henderson and F&C.

These more complex funds supplement low-risk cash or cash-like assets with investments in corporate debt and longer-term securitised loans. They can generate superior returns – they typically aim for around 30 basis points above Libor, the interbank lending rate – but increased defaults and a severe tightening of liquidity mean recent performance has been lacklustre, to say the least.

“A number of funds have been going arguably outside of their mandate for cash and taking considerable excess risk,” says Andrew Wilson, head of investment at Towry Law, the adviser. “In some cases the returns have been a disgrace.”

Robert Harley at Bestinvest says one problem is the lack of transparency over exactly where these funds invest. “The ratings were not a fair reflection of the quality of underlying assets,” he says.

Research from UBS Wealth Management found the average return from enhanced cash funds in the last five years was 0.44 per cent below the money market.

Only 14 per cent of enhanced cash funds issued in the past five years managed to provide returns above money market investments after fees. Funds issued more recently showed even worse performances.

“The majority of funds simply haven’t delivered,” says Brian O’Reilly, head of UBS Wealth Management Research in the UK. “Investors need to take a more prudent approach and be very aware of what assets the fund is really holding. They may be better off paying a premium for higher quality managers.”

With high street banks and building societies offering saving rates close to 7 per cent, it is questionable why investors would want to take any additional risk with their cash investments.

One reason is diversification. Only a proportion of cash savings – £35,000 per institution – is protected if a bank or building society collapses. Investors with substantial funds might therefore choose a cash fund to split their money between different institutions.

Cash saving rates are also more vulnerable to change and the best rates typically require investors to lock in for six months or a year.

“Banks have some good rates at the moment and so do cash funds,” says Peter Hicks at Fidelity, which offers a cash unit trust. “But bank rates can fluctuate for reasons other than interest rate falls.”

He says saving providers might launch new accounts with high rates at the detriment of older accounts. Savers therefore have to check what rate they are receiving on a regular basis.

“With cash funds, you are not so likely to end up with an out-of-date account,” says Hicks.

Money market type funds, also offered by Barclays, JPMorgan and L&G, typically offer similar yields to Libor. Fidelity’s fund is offering 5.7 per cent gross after charges, for example.

They invest in very short-term lending facilities offered by banks and other financial institutions. The investments are typically AAA-rated and have maturities of no longer than three months, and often just a week or two.

“We would recommend the more conservative, larger, short-duration funds rather than the more exotic investments,” says Wilson. “It might be worth investors giving up a few basis points to make sure they have something secure.”

Some of these funds are based offshore, which brings an added tax advantage (see right).

However, this advantage came about as an unexpected consequence of changes in the Budget, so advisers fear it could be closed down.

Anyone who would rather keep money in a bank or building society account will now find plenty of attractive rates to choose from.

Banks and building societies have been launching new fixed-rate bonds in recent weeks to attract new retail deposits. Many accounts are now paying between 6.4 and 6.8 per cent for either six months or a year.

The best accounts, according to Moneyfacts.co.uk, include Birmingham Midshires’ one-year bond, paying 6.81 per cent and Icesave and Alliance & Leicester’s six-month bonds, paying 6.75 per cent and 6.72 per cent respectively.

But the Bank of England’s move this week to alleviate lenders’ liquidity problems could mean they are less reliant on retail deposits so these high rates may not be around for too much longer.