Assess money market risk

Money market funds can’t lose money. That has become an axiom of mutual fund investing.

Well, beware. That may no longer be the case. If short-term interest rates fall much more, money
market funds with unusually high management expense ratios (MER) could find themselves in a
situation in which their costs exceed revenue. In fact, some could already be facing a crunch.

As of December 7th, the institutional rate on Government of Canada three-month Treasury bills, which form the core of many money market funds, was 2.05 per cent.

That was the interest rate being paid on transactions over $1 million. Retail investors received less. Commercial notes offered a bit more, but not a lot. Three-month rates quoted in The Globe and Mail Report on Business were 2.19 per cent.

Some money market funds are showing current yields at higher levels than the T-bill and
commercial short-term rates. Those MMF yields will drop over time, as the short-term notes the
funds hold come to maturity and are rolled over.

Dangerous territory
Some funds have already fallen below a 2 per cent current yield and this is where we get into dangerouterritory.

• The average MER for Canadian money market funds is 1.06 per cent.
• However, eight funds have an MER of 2 per cent or higher (the most being 2.5 per cent)
• Another 18 have MERs between 1.5 per cent and 2 per cent
• A further 23 show MERs of 1.25 per cent to 1.5 per cent.

So what happens if the expenses on a money market fund exceed its revenue? It operates at a
loss, of course. With any other type of mutual fund, that would mean a drop in the net asset value
(NAV).

No guaranteed value
However, money market funds have a fixed NAV, usually $10, which investors assume
is guaranteed.

Actually, it’s not. In extreme circumstances, a fund’s NAV could decline. However, MMF
managers would be very reluctant to do that because of the blow it would deal to public
confidence in the funds.

Next page: What options?

What options?
So what are the options? One, which has been used on rare occasions in the past, is to apply
negative interest.

Instead of receiving more units at the end of a month when the fund’s distributions are reinvested, you will actually have some units subtracted from your total holdings to reflect the negative position of the fund.

Other possibilities for dealing with this kind of situation include:

1) Letting the NAV drop. This is considered highly unlikely.

2) The sponsoring company subsidizes the fund to the extent needed to make up the deficiency.
Investors would get no payment, but the NAV would hold and the number of units would remain
unchanged.

3) A waiver or suspension of part or all of the management fee.

Assess risk
As an investor, you should not put yourself in a position where you might be at risk in this
situation. Many of the funds with high MERs are segregated (insurance company sponsored).

So if you are holding a segregated money market fund, you should take a close look at it. If it has a high price tag, consider switching the assets into a different type of fund.

The lowest MER funds tend to be no-load offerings from the banks and traditionally low-fee companies like Phillips, Hager and North.

So check the current MER of any money funds you own. If it is over 1 per cent, you may want to look for an alternative.

Adapted from the December issue of Mutual Funds Update