Exchange-traded funds (ETFs) are adaptable instruments used for many purposes. This week we will look at how they can used to provide dependable, decent income.
Money-market ETFs share many of the advantages seen on bank-offered term deposits, but with potentially superior yield. The concept is not new. For decades, investors have been buying unlisted mutual funds that invest solely in market-market instruments.
To get a bit of terminology out of the way, money markets are an essential, but rarely discussed, component of global finance. The market specialises in short-term finance and lets banks, government agencies, municipalities and corporations find the day-to-day liquidity needed to stay up to date on their many obligations and regulatory requirements.
Because the borrowing is short term - the time period for lending can be up to one year, but usually the loan is measured in days or weeks - the risk of default tends to be low. After all, few lenders' creditworthiness will deteriorate significantly in the span of weeks.
Money markets are rarely discussed because they are a bit dull. Apart from periods of extreme stress (such as was seen in 2008, following the Lehman Brothers bankruptcy) money markets tick over with a high degree of reliability. The returns are not exciting, but they are reliably better than bank deposits and, when markets are tanking, dullness can be a virtue.
Money market ETFs can be particularly useful when an investor just wants to put his or her money into a reliable, income-paying fund.
'Holding some cash makes sense, but it should be a limited amount or time. This is because even at low inflation rates, cash savings will be eroded by inflation over time. Holding too much cash is not the way to build wealth,' says Sandra Lee, BlackRock's head of iShares Asia ex-Japan.
Money-market ETFs are an alternative to term deposits or certificates of deposits. They generate yield by investing in low-risk securities, such as commercial paper and US Treasury bills, with maturities equal to certificates of deposit (CDs).
Money market ETFs are appealing because they generally offer higher interest rates than banks' CDs, and they typically offer lower fees and expenses than those seen on comparable money market mutual funds, says Marco Montanari, head of Deutsche Bank ETFs and db-X funds, Asia.
One such ETF is iShares Barclays 1-3 Year US Treasury Bond Fund, which tracks a short-term US Treasury index and is listed on the New York Stock Exchange. 'We are seeing increasing interest in Asian local currency sovereign bond ETFs as investors look for yield enhancement and potential currency appreciation,' Lee says.
Investors looking to hold cash for shorter periods can buy Deutsche Bank's AUD Cash ETF. It is the only Hong Kong-listed ETF linked to an official money market rate.
Its performance follows an index tracking the overnight interest rate published by the Reserve Bank of Australia. The fund is in Hong Kong dollars, and the Australian assets it tracks are Australian dollar denominated, which means the fund involves exchange-rate risks.
Montanari says the fund is suitable for investors who seek overnight returns and want to bet on an appreciation of the Australian dollar versus the Hong Kong dollar.
It is tradable during the exchange session like any of the other listed securities.
Last year, the fund made an annual return of 4.25 per cent in Australian dollars. As a point of reference, HSBC advertises on its website a 12-month term deposit in Hong Kong, in Australian dollars, that pays 2 per cent per annum.
There are key differences between bank term deposits and money market ETFs. In a bank deposit, you have 100 per cent risk exposure to the issuing bank in the event of a default. However, you are also protected in Hong Kong by the terms of the government's Deposit Protection Scheme. You are also locked into holding the deposit until maturity unless you pay an early withdrawal penalty.
Montanari describes the risks of the Deutsche money-market ETF thus: in case of default, the bank is committed to paying interest while an investor's principal is protected by collateral - in this case, a basket of sovereign bonds.
'Unlike bank term deposits, money market ETFs have real-time liquidity given that investors can buy and sell them any time during the stock exchange's trading session. But their returns are linked to the overnight rate. Hence, its return can be higher or perhaps lower than a fixed bank deposit,' Montanari says.
Investors choosing between a term deposit and money market ETF should, therefore, consider yield, length of investment, the credibility of the bank or issuer and the amount that is protected by deposit insurance schemes.