Has your money market fund compensated you for your risk?

A money market mutual fund refers to the category of fixed income mutual fund that invests in debt instrumentswith short maturities and marginal credit risk.

If you are an investor that has committed money to any of the money market funds in Nigeria, then you must take time to evaluate the performance of your fund managers to ascertain whether they have really added value to you.

Considering that your objective is to grow your wealth, you should seek value in other available alternative instruments if your fund manager has not grown your money in terms.

So, hop in let me drive you through the process of evaluating the performance of your money market fund manager so you can effectively make the decision to either hire or fire.

What is the total return of a money market fund?

Total portfolio return comprises the difference between the values of any portfolio from the beginning of an investment period to the end of an investment period, incorporating any income provided by the portfolio within the period.

Mathematically speaking, you can express this as:

R_p = (Ending net asset value/Beginning net asset value-1)*100

Where R_pis the investment period portfolio return

As an investor, you can use the above practical formula to make an informed decision, but you also need to adjust the numerator (i.e. the net asset value) for any additions to or withdrawals from the fund within the period you are considering.

To illustrate, let us assume that your money market fund had net asset value of N13,695,234,981.19as at the December31, 2015 (this is the ending net asset value) and N13,822,882,964.56 as at January 1, 2015 (this is the beginning net asset value).

Furthermore, let us assume that new investors committedN1,500,000,000.00 to the fund, while existing investors redeemed (that is, withdrew) N2,000,000,000.00 from the fund  during the year.

Our numerator above will be equal to N14,195,234,981.19 (N13,695,234,981.19+N2,000,000,000.00-N1,500,000,000.00), and when you substitute the values into our equation above, you will realise that your money market fund posted a total return of 2.69 per cent.

Is the total return measure sufficient?

The total return only gives you a quick indication of how your fund manager has performed during the year, but it does not tell you the whole story.

Remember that you have invested in the fund with the conviction that your managers will be able to generate returns that will compensate you for the risk you are taking by trusting them with your money, rather than investing it in an alternative asset.

Add the management fees that your managers charge your every year, about 2 per cent of the fund’s net asset value, and you will decide that your managers should generate even more returns for you.

Realising this, experts have evolved two generally accepted tools for capturing the risk investors will be taking by engaging the services of fund managers, the Sharpe Ratio and the Information Ratio.

Out of the above tools, the information ratio helps you to gauge the ability of your manager to generate excess returns relative to the benchmark. So, this toll lets you to whether the risk you take by investing in the fund is really worth it.The equation is as follows:

IR = R_p – R_b/S_p/b

Where

IR is the information ratio;

R_pis the return on the money market fund, similar to the total return we calculated above;

R_bis the return on the benchmark portfolio;

S_p/b is the standard deviation of the difference between the money market fund returns and the benchmark portfolio returns. This is called tracking error by the industry, and is an approximate measure of the inherent risk in the fund.

Without boring you with details of the above formula, you should know that the higher the ratio, the more you are compensated for the risk you take on. So, what will you do if the IR of your money market fund manager is not high enough?

 

Innocent Unah