There are not one, but three, ways in which you can invest indirectly in the wholesale money market. Part 57 of our Scrapbook Series explains the workings of money market bank accounts, money market unit trust funds and money market life products.
Just as you, as an individual, may need to borrow or invest money, so banks and other financial institutions need to borrow and invest money. The money market is where financial institutions go to lend and borrow large sums of money.
What are known as short-term financial instruments - instruments which, for the most part, mature in one year or less - are issued and traded in the money market.
The money market consists of the retail market, in which individuals can participate, and the wholesale market, which, because of the large sums of money involved, is open only to banks and financial institutions. Banks obtain some of the funds that they lend to their clients from the wholesale money market.
Individual investors can participate in the retail money market via securities such as bank call accounts, notice deposits and vehicle finance.
Various types of securities are traded in the wholesale money market. These securities can be broadly divided into interest rate instruments and discount instruments.
Holders of interest rate instruments receive interest on the amount they invest. Examples of interest rate instruments include negotiable certificates of deposit, short-term debentures and short-term gilts.
Holders of discount instruments do not receive interest on the amount they invest. Instead, they are issued at a discount to their redemption amount (in other words, the guaranteed amount on maturity). As the issuer of the instrument does not pay interest, investors expect to pay less than the redemption amount when they invest. Examples of discount instruments include banker's acceptances, treasury bills, promissory notes and commercial paper.
Individuals usually do not have direct access to interest rate and discount instruments because of the large sums of money involved.
Individuals who want to invest in the wholesale money market may do so indirectly via unit trusts, a money market deposit account usually offered by a bank or a money market investment policy from a life assurance company.
MONEY MARKET DEPOSIT ACCOUNTS
A money market deposit account gives you a high rate of interest, easy access to your money and the ability to transact from your account.
What it is
A money market account is similar to any other investment at a bank, such as a fixed-term deposit or a notice deposit. You deposit your money into the account and earn interest on that money for as long as your money remains invested.
How it works
When you invest with a bank, the bank becomes the custodian of your money. The security of your investment ultimately depends on the financial strength of the bank with which you invest.
Some money market accounts limit your transactions to deposits, withdrawals and inter-account transfers, while others allow you to conduct the full range of transactions (including stop and debit orders). The reason some accounts limit the type of transactions is to encourage you to use the account for investing rather than transacting. The way transaction fees are structured is also designed to encourage you to keep your money invested.
For instance, on the transaction accounts, there may be minimum monthly fees and transaction fees, whereas investment accounts will offer fewer features and lower fees.
The minimum opening deposit can be R5 000 or R10 000, depending on the bank, and institutions may vary the amounts from time to time. The higher the deposit, the higher the rate of interest. The higher rates only kick in at about R20 000.
The account is administered by a bank as a normal investment account and interest is calculated on a daily basis and capitalised to your account once a month.
Advantages
The main advantages of money market deposit accounts include:
- Your money is not locked into a specific investment term, as is the case with a fixed or notice deposit. You can deposit your money into a money market account today and withdraw it tomorrow without having to give the bank notice. Obviously, the longer your money remains in the account, the more interest you will earn.
- Your capital in a money market account is guaranteed.
- The interest rates are more stable than with money market unit trusts. Although the rates may vary, they rarely move unless the prime lending rate changes.
Disadvantage
Your investment becomes part of the bank's assets. Although the bank is obliged to repay your capital investment and the promised returns, if the bank collapses - as occurred with Saambou - you stand to lose all or some of your money, depending on the extent to which the failed bank's liabilities exceed its assets.
Who should invest
Money market accounts are aimed at conservative investors who want to take as little possible risk with their investments. They are also suitable for people who want to earn interest to either supplement their income or provide them with an income.
Where to buy
Most banks offer money market accounts. It is advisable to shop around because the interest rates and the minimum investment amounts vary between the banks.
Costs
Unlike unit trust funds or investment policies, there are no investment charges on bank deposits. However, you are charged transaction fees for cash deposits, withdrawals, transfers, and for stop and debit orders. These fees vary between banks. The cash handling fee for cash deposits can be as high as 0.7 percent of your deposit amount. Some accounts, those that offer greater transactionality, may also have minimum monthly fees.
Tax
You pay tax on any interest earned on a cash investment. But a portion of the interest that you earn from all you investments in a single year is exempt from tax. Currently, if you are under 65, the first R11 000 of interest income is tax-free, and if you are 65 or older, the first R16 000 of your interest income is tax-free.
Your bank will send you a tax certificate showing the interest your investment earned during the tax year and you must declare this amount on your tax return.
MONEY MARKET UNIT TRUSTS
After many years of resistance from the banking sector, which had a monopoly over the investment of short-term funds, money market unit trust funds were introduced in South Africa in 1998.
What it is
A money market unit trust fund is similar to other unit trust investments. Your money is pooled with that of other investors, and is then invested in various assets by professional investment managers.
Unit trust funds may invest in shares, bonds, property and cash or a combination of these assets. In the case of a money market unit trust, the underlying investments are money market securities.
Money market fund managers specialise in placing your money, on the best terms possible, with institutions that wish to borrow money for short periods, usually less than one year. The average duration of the portfolio may not exceed 90 days. (The average duration of the portfolio is the average time within which all the instruments held by the portfolio must repay their loans.)
Money market unit trusts are classified in the fixed interest category.
How it works
The structure of a unit trust fund consists of three components: the fund, the trustee, and the collective investment scheme manager.
The fund consists of the cash contributions make by investors. In the case of money market unit trusts, the pool of cash is invested in money market securities.
Unit trusts are governed by a trust deed issued under the authority of the Financial Services Board. The fund has to appoint a trustee, who exercises fiduciary control of the fund. The trustee is the custodian of all the cash and securities within the fund, and it is his or her duty to protect investors from having their funds misappropriated.
The collective investment scheme manager is the administrator of the fund. A team of investment managers, who either work for the management company or who manage the fund on the company's behalf, makes the investment decisions and arranges for securities to be bought or sold.
You are allocated units in the fund based on how much money you invest. You can cash in your units within about two working days.
Money market unit trusts are suitable if you want to invest over the short to medium term, and do not mind the fluctuations in the interest rates in the investment market.
Interest on the unit trust portfolio is earned daily, and is distributed to investors monthly in arrears.
Advantages
The advantages of money market unit trusts include the following:
- You can sell your units at any time, because money market funds are compelled by law to buy back your units.
- The minimum investment amounts are low.
- You can arrange to invest a set amount monthly and if this no longer suits you, you can change the amount you invest each month or stop contributing altogether.
- A professional investment manager manages the underlying investments to get you the best possible interest rate.
- The Collective Investment Schemes Control Act requires that the assets in a money market unit trust are held in a separate trust, and do not become part of the assets of the company managing the unit trust. This means that if the management company folds, the assets in which you are invested are safe.
The fund cannot be invested in securities issued by a single issuer. This ensures a measure of diversification and reduces the risk of you losing your investment if one issuer defaults on its repayments.
Disadvantages
The disadvantages of money market unit trusts include:
- Although money market unit trusts do not come with guarantees your capital, it is unlikely you will lose your money.
- Your returns are not fixed, as the money market rates change daily.
- The historic returns quoted on money market unit trusts exclude the upfront fees, but do include the annual fees.
Who should invest
Money market unit trusts attract investors who want an income stream. Investors often use money market funds as a place to "park" their money while they decide where to make a long-term investment.
Minimum investment amounts
You can invest in a money market unit trust either with a lump sum or on a monthly basis via debit order. The minimum lump-sum investment can be as low as R5 000 or as high as R50 000, depending on the fund. The minimum monthly investment ranges between R200 and R5 000.
Where to buy
You can buy money market unit trusts from most of the major unit trust companies. Currently, about 20 money market funds are available.
Costs
The investment costs for money market unit trusts tend to be lower than for investment policies and money market deposits charge for transactions and not for investing.
In the case of a unit trust, you can generally expect to pay two different sets of costs: an initial, or upfront, fee and an annual fee. Most money market unit trusts do not charge initial fees. The annual fees tend to be as high as 0.5 percent.
Tax
You pay tax on any interest your money market unit trust earns from its investments. But a portion of interest that you earn from all you investments in a single year is free of tax. Currently, if you are under 65, the first R11 000 of interest income is tax-free, and if you are 65 or older, the first R16 000 of your interest income is tax-free.
Your fund will send you a tax certificate showing the interest earned and you must declare this amount on your tax return.
Money market life products
The main difference between a money market unit trust fund and a money market life product is the holding structure through which your money is invested.
In the case of a money market unit trust, the assets are held by a trustee, who acts as the custodian, on the investors' behalf, of the cash and securities in the fund. The trustee is independent of the management company. In the case of a money market life product, the holding structure is a life assurance company.
What it is
When you invest in a money market life product, you typically place your money in an investment, or endowment, policy.
Endowment policies offer you a choice of underlying unit trust investments. You may invest either across the range of different types of unit trust funds, or in segregated portfolios. Segregated portfolios are made available only to financial institutions, such as life companies.
You can switch the underlying investments.
How it works
When you invest in an endowment policy, you hand your money to the life assurance company, which holds the investment on your behalf. So, the life company becomes the custodian of your investment.
Investors are protected by the rules and requirements of the Life Offices' Association and the Financial Services Board.
Advantages
The advantages of money market life products include the following:
- If you are on a marginal tax rate of more than 30 percent, you can benefit from the lower tax rates that apply to an investment policy. The fund pays tax at a rate of 30 percent on any interest and rental income received by the fund's investments. The proceeds of the policy are paid out to investors tax-free.
- Flexibility. You may easily switch between the various asset classes and between local and offshore investments.
- You may invest in single lump-sum amount and/or by paying in regular premiums.
- Your investment is managed either by the life company's in-house management team or by external asset managers with whom the life assurer has contracted.
Disadvantages
The disadvantages of money market life products include:
- You are locked into the investment for a minimum of five years. There are penalties if you surrender, or cash in, your policy before the maturity date.
- You pay early surrender penalties if you redeem your policy before it reaches maturity.
- The costs are high and not very well disclosed, although disclosure is slowing improving.
- Up-to-date portfolio values are not always readily available.
- Endowments come either with or without capital guarantees, but guarantees always come at a cost, which means you will get lower investment returns.
Who should invest
If exposure to the money market is all you are looking for, investing into the money market via an investment policy is not the best option, because you will have to pay a double layer of costs. You have to pay the costs associated with the investment policy itself as well as the costs on the underlying investments.
If you are looking for some money market exposure as part of a broader investment strategy, an investment policy may work for you because it offers flexibility of underlying investments and a tax benefit if your marginal rate is more than 30 percent.
Minimum investment amounts
The minimum lump sum is about R15 000, and the monthly premiums are about R200. The amounts may differ between life assurers.
Where to buy
You can buy a money market investment policy from any life company.
Costs
The cost structure of life products can be complex. This is compounded by the fact that life companies often sell investment policies under separate brands, each with a different cost structure. For instance, some policies deduct the fees and commissions upfront, while others spread the commissions and fees over the full term of the policy.
Importantly, you may have to pay initial and annual costs on both the endowment policy and on the underlying investments.
Tax
The main benefit of a money market life product is that the fund pays tax at 30 percent on any interest and rental income it receives. This is lower than the top marginal rate of 40 percent, which high-income investors pay on their personal income. The proceeds of the policy are paid out to investors tax-free.
Part 58:
Hedge funds