Money market funds beat Isa deposits

Investors holding cash in stock market individual savings accounts (Isas) or self-invested personal pensions (Sipps) are earning near-zero interest, but switching into money market funds for potentially higher returns means additional risk, warn experts.

With the base rate stuck at a record low of 0.5 per cent for approaching two years, most stockmarket Isas and low-cost Sipps pay zero or virtually no interest on cash. Across the Sipp market, including more flexible plans, the average default cash account pays only 0.21 per cent on a £5,000 balance, according to analysts Defaqto.

While most people invest these tax-sheltered portfolios in the stock market for growth, many choose to be in cash in the run-up to retirement or because they fear share prices will fall.

Flexible Sipps can offer access to external cash accounts or fixed-rate savings deals paying up to about 3 per cent, but these plans often carry higher charges. However, for stockmarket Isas and low-cost Sipps without such alternatives – including those of Hargreaves Lansdown and Sippdeal – money market funds are one of the very few cash-like options for earning an improved return.

While most of these funds have produced returns of only up to 0.5 per cent in the past year, the top performers have made about 2 per cent. For a tax-efficient investor with £10,000 in cash this would equate to a £200 profit.

But although these managed funds can deliver better returns, experts warn that investors do not have the same capital protection as with a deposit account. Despite many funds being branded “cash”, they typically invest in short-term money market instruments whose value can fluctuate.

The potential risks were highlighted by a sudden 4.8 per cent drop in the unit value of Standard Life’s Pension Sterling Fund in 2009 after a revaluation of asset-backed securities in the fund. The insurer’s failure to make clear the fund’s risks prompted a £2.45m fine from the Financial Services Authority.

M&G’s High Interest fund, one of the best performers over the past year, was also down nearly 10 per cent at one point in 2008 as concerns over the bank issuers of floating rate notes (FTNs) hit the capital value of holdings. Manager Ben Lord says that the fund’s returns should be linked to Libor, the interbank borrowing rate. Currently, he says it is earning about one percentage point over Libor’s 0.75 per cent.

M&G High Interest is the only money market option available through Alliance Trust’s Isa and low-cost Sipp. Investors benefit from a 0.25 percentage point rebate of the annual charge but pay a £12.50 dealing cost. Alliance Trust, whose Sipp deposit account currently pays zero interest, says it does not generally offer money market funds as it wants to make an interest margin from cash holdings.

M&G’s is also the only money market fund available through Hargreaves Lansdown’s Isa – albeit for an extra 0.5 per cent plan charge.

The Investment Management Association says that one advantage of a money market fund over a standard cash deposit is the diversification of counterparty risk, as holdings are spread across institutions.

Investments in money market funds are currently protected up to the same level as cash – £50,000 under the Financial Services Compensation Scheme (FSCS), although the safety net for deposits is increasing to about £85,000 from the end of the year. Justin Modray of CandidMoney.com, the financial website, also points out that the FSCS does not cover losses within a fund that may occur if an issuer backing the instruments fails.

Anna Timms, director of InvestmentSense.co.uk, a website that lists savings accounts for more flexible Sipps, warns that the best funds have generally had the most volatile returns, while charges of about 0.5 per cent also eat heavily into returns in the low-
interest rate environment.

For investors with relatively small cash balances held for short periods, the current returns on money market funds may not be sufficiently attractive, Modray says. “However,
for investors liquidating their whole portfolio they may be worth it – but you do need to know what you’re buying.”