Meet Arya Storm and Max Tennyson
Before we launch into the nuances, let us introduce you to two individuals – Arya Storm and Max Tennyson.
Arya is a young 28 year old marketing professional. She works with an MNC at a senior level position and earns a comfortable living for herself. Arya has completed her higher education and currently does not foresee any huge expenses. She has a corpus of $30,000 that she wants to invest with the objective of high returns.
Max is a general manager and is 50 years old. He lives with his wife and plans on retiring in another 5 years. He lives a comfortable lifestyle and would like to maintain his standard of living post retirement. Max wants to start planning for his retirement savings.
They are two very different individuals but they share one common element. Both have allocated some proportion of their investment corpus into Money Market Securities.
Why? We elaborate the same in this post.
But First, Some History…
Fixed income instruments as an investment strategy have been around since the 17th century; having found purpose for myriad reasons. Contextually, fixed income securities are debt instruments issued by a government, corporation, or any other entity to fund their operations. These securities give an opportunity to investors to receive fixed periodic payments at regular intervals and a principal payout at maturity, in return for lending money to the respective entity.
Money market securities include instruments which are highly liquid and stable. Bonds, Commercial Papers, and Certificate of Deposits which mature in a span of 91 days or lesser are typically classified under this category.
Money market securities are gems for investors who want to secure their cash and play it safe when markets are going through turbulence. Debt instruments with longer term maturities or corporate bonds attract interest rate risk and credit risk which is minimised in money market securities. We have elaborated how these risks affect debt securities in this article.
Breaking Down Money Market Strategy
A money market strategy is a basket of securities which classify as money market instruments due to some inherent characteristics, which have been explained below. The strategy can include the following instruments:
– Treasury Bills
Treasury bills are issued by the central government and are considered to be the safest money market instrument available. Due to its vast safety net, the returns on treasury bills are fairly modest. Treasury bills are issued by the central government at a lesser price than their face value. The interest earned by the buyer will be the difference of the maturity value of the instrument and the buying price of the bill.
– Sovereign Bonds
Like treasury bills, sovereign bonds are issued by the central government but have a longer term maturity than bills. These bonds can have a maturity of greater than 7-10 years. Sovereign bonds are extremely low risk instruments since the probability of default by a country is very low.
– Municipal Bonds
Municipal bonds are issued by local governments, cities or states and are often referred to as ‘munis’. They are slightly riskier than sovereign bonds since the probability of a city defaulting is greater than that of a country. The interest on municipal bonds is completely tax free which serves as a major plus for investors.
– Corporate Bonds
Corporates are major issuers of bonds and constitute a large chunk of the bond market. Corporate bonds maturing in less than 5 years are termed as short-term bonds, intermediate is five to 12 years, and long-term is over 12 years. The returns on corporate bonds are higher since the probability of a company defaulting is relatively higher which increases the corresponding yields. Credit ratings play an important role while assessing corporate bonds. Bonds issued with a higher credit rating are considered investment grade bonds and ones with lower credit ratings are termed as junk bonds.
b) Certificate of Deposits
A Certificate of Deposit is a document issued by banks to investors who commit to depositing money in the bank for a specific period of time. Unlike a savings account, investors cannot withdraw money from a CD until maturity. CDs can have a maturity period of 1 month, 3 months or more. Due to its restrictive nature, CDs normally provide higher interest rate than savings account. These are considered to be extremely safe instruments.
c) Commercial Papers
A Commercial paper is a short-term money market instruments which matures in a period of less than 270 days. These are issued by organisations for covering short term liabilities and account payables. CPs are issued by firms with very high credit ratings and are sold at a discount to the face value.
Investing In Money Market Strategy: The Why
As stated above, money market strategy constitutes securities with very low maturities. These are safe instruments which offer fixed returns to investors over the period of investment. Investors receive the principal amount at maturity.
Money market instruments are highly liquid because they are fixed-income securities which carry short maturity periods of a year or less. These strategies can be actively managed to optimise on interest rate movements and market outlook. During periods of interest rate volatility an active strategy can help investors move out of instruments whose NAVs are likely to be impacted due to an increase in rates or vice versa.
Money market instruments also have the potential of giving investors higher returns than a savings account and a fixed deposit primarily due to its fundamental characteristics.
So, if we had to really get someone interested in investing in money market strategies, we would repeat these four points like a mantra:
a) Stable Returns
b) High Liquidity
c) Active Management
d) Potential for Higher Yields
Money Market and Your Portfolio: Does It Fit?
A 2000 study by economists Roger Ibbotson and Paul Kaplan concluded that more than 90% of a portfolio’s long-term returns were driven by its asset allocation. While this study was more relevant for institutional investors and fund managers, the importance of asset allocation holds true for individual clients as well.
The modern portfolio theory by Harry Markowitz states that assets should not be weighed by their risk-reward proposition individually but, rather, by how each asset fits into an overall portfolio. This is a key takeaway for investors as they make decisions on how much corpus to allocate to different securities.
The theory is based on 2 main concepts :
a) An investor will maximise return for any given level of risk
We can understand this with a simple example. Assume there are 2 portfolios – X and Y. Portfolio X can give a return if 15% with a standard deviation of 3%. Portfolio Y can give a return of 12% with a standard deviation of 3%. This effectively means portfolios X and Y can provide a return in the range of 18 – 12% and 15 – 9% respectively. A rational investor will always choose portfolio X since it provides a higher return for the same level of risk.
b) Diversifying the portfolio by including unrelated assets reduces risk
This concept can simply be understood with the idea of correlation. When 2 or more assets are very similar, their prices will move in similar directions. As a result, when investors hold a basket of similar assets, their portfolios can take a massive hit when the value of these assets fall due to any adverse conditions.
The key to avoiding this is to hold assets that are unrelated to each other i.e. have less correlation. This lack of correlation is what helps a diversified portfolio of assets have a lower total risk.
Thinking on these lines, the percentage allocation to money market strategy is a function of your overall portfolio design. A very popular and useful exercise is to subtract your age by 110. Take the example of a 25-year old professional who earns a fixed salary from a stable job. The investor can subtract his age from 110, which in this case is 85. The investor should allocate equity and debt in his portfolio in a ratio of 85:25. A 25-year old can take this risk since he/she has a longer term horizon and can take greater risks with his / her investments. As investors grow older, their portfolio mix gets more conservative.
The debt portion of your portfolio ensures a fixed and steady returns throughout the lifecycle of your investments. It acts as a cushion when you are in need of cash and when your equity portions take a hit. Diversification helps investors to ensure that a portion of their capital stays protected even during periods of high volatility in capital markets.
Now that we understand how the math works, let us look at how one can apply this to their asset portfolio and create a resilient investment strategies. Let us go back to Arya and Max and understand their allocation to money market strategy.
Young and with an accelerated career, Arya’s income is likely to increase in the coming years. She should adopt an aggressive strategy and allocate a large portion of her corpus into equities to fulfill her objective of earning higher returns. At the same time, she should allocate a small percentage to money market strategy to ensure that she has cash on hand for urgent needs.
Since Max plans on retiring in another 5 years, he should adopt a very conservative strategy. Max should allocate majority of his investment into debt instruments to ensure a fixed income flow. He should also allocate a significant portion to money market securities rather than long term debt to ensure liquidity. This would meet Max’s primary goal of asset preservation.
Making the Right Choice: Money Market Strategy vs. Other Options
There are 3 primary options that investors have when they want to keep their money in safe and liquid form – Money Market, Savings Accounts, and Fixed Deposits. To understand what works best, let’s do a fact check for each of these options:
|FEATURES||MONEY MARKET||SAVINGS ACCOUNT||FIXED DEPOSIT|
|RETURNS||Higher than other options||About 1.5% p.a.||About 1.88% p.a.|
|LIQUIDITY||High liquidity||High liquidity||Locked-in, based on maturity|
|EXIT LOADS||No exit loads||No exit loads||Penalty for early withdrawal|
|ISSUING AUTHORITY||Central govt. & state banks, corporations||Banks||Banks|
As is apparent, the Money Market strategy is a better option by virtue of higher yields with the promise of high liquidity.
Markets in 2019 and The Impact on Money Market
We started 2019 on a volatile note with several international factors looming over the markets. As mentioned in our market outlook report for 2019, here is a snapshot of the top factors that will dictate market trends.
Outlook for Equity Markets
Equity markets are expected to remain volatile in 2019 until there is further clarification on certain key global events.
The U.S. Stock Markets
American markets will be dictated by several key trends. The critical two being:
1. There is little clarity on the on-going U.S.-China trade war. Trade talks have been going on and both the countries have stopped imposing tariffs on each other. However, the two superpowers are yet to reach a conclusion and markets can move south in case the talks fall apart.
2. The forward estimates for most companies are unfavourable due to the high risk that they foresee on account of negative global cues. The risk is high and probability of returns is low. In such a scenario, we do not find it advisable to invest in equities.
China has been experiencing stagnant growth which is reflected in its GDP numbers. Along with U.S.-China trade talks, the economy is sitting on huge debt and is facing the prospect of an ageing population. We expect its slow performance to continue at least till Q2.
European markets will be influenced by the direction Brexit takes in the coming months. Based on developments in the past few weeks, May’s government might not be able to meet the March 29th deadline for officially quitting the European Union.
So, what should your money market investments in 2019 look like?
With volatile times likely to continue, it does make sense to park some of your assets in MM instruments. It might be better to watch the equity markets play out from the stand rather than participate in a race which can take uncertain turns. Given the current scenario, a money market strategy which invests your money in liquid securities can act as an asset preservation tool. As markets settle, investors can move their funds into equities and opt for different investments.
The materials and data contained herein are for information only and shall in no event be construed as an offer to purchase or sell or the solicitation of an offer to purchase or sell any securities in any jurisdiction. Kristal Advisors does not make any representation, undertaking, warranty or guarantee as to the update, completeness, correctness, reliability or accuracy of the materials and data herein. All opinions, forecasts or estimation expressed herein are subject to change without prior notice. Kristal Advisors and its affiliates accept no liability or responsibility whatsoever for any direct or consequential loss and/or damages arising out of or in relation to any use of opinions, forecasts, materials and data contained herein or otherwise arising in connection therewith.