Ideas & Debate

There is no such thing as risk-free investment

Lehman Brothers at the height of the financial crisis in 2008. There is no such thing as an investment that carries not risk. FILE PHOTO | NMG
Lehman Brothers at the height of the financial crisis in 2008. There is no such thing as an investment that carries not risk. FILE PHOTO | NMG 

Plenty of half-truths regularly circulate the markets, some of which you simply can’t afford to believe.

Plain myths aimed at fooling the simple-mind. One enduring idea (sold and told by pros) is found in the industry phrase: risk-free – often used to refer to money-market investments.

The truth is; no such thing exists. No asset is risk-free. This is a huge misnomer. A horrible inaccuracy. And here’s why you should have the same mind on the same.

But first, a brief introduction on money market funds; these are mutual funds designed to maintain a constant Sh1 per share net asset value. In other words, investors can expect Sh1 back for each Sh1 invested.

According to the Capital Markets Authority (CMA) Q4 2017 report, these “risk-free” funds accounted for roughly 80 per cent of the total mutual fund assets under management. Equity funds stand at a distant second (11 per cent of total assets).

Back to the matter at hand. One fund risk is illiquidity. Throughout history involving money-market funds, there have been plenty of instances where they have “broken the buck” – net asset values falling less than Sh1 per share. One famous case is the Reserve Primary Fund.

In 2008, the fund, which held Sh78.5 billion in Lehman-issued securities, became illiquid when the fund was unable to meet investor requests for redemptions.

The following day, it “broke the buck.” Its failure sparked an epic run on money market funds. Research now shows that during the great financial crisis (GFC), a number of money-market funds fell underwater and had to receive cash injections from their fund sponsors (and even bail-outs) to hide this fact.

The other risk is inflation. With most money market funds yields dancing at 6-8 per cent, it means real-returns (inflation has averaged six per cent annually in the past three years) are mostly negative.

That doesn’t seem very attractive. Not being able to preserve your basic purchasing power increases the risk of not being able to meet your long-term goals.

Unless you’ve invested in the short term – less than a year - , any long-term funds should be placed in stocks. Stock returns should deal with the inflation monster. Inflation is a real but subtle risk that most investors don’t pay attention to.

Interest rate risk is another. Although money market funds rates offer to give a return on your principal, this is not always the case as witnessed after the GFC.

As European central banks pushed their base rates below zero in order to reflate their economies, some money markets funds fell inside the negative territory (and stayed there for a long while).

To get the picture, consider this; a five-year Treasury bond yielding a negative 0.3 per cent. This produces a price of Sh101.5, which means investors get back Sh100, five years from now for every Sh101.5 invested today.

With Treasury bonds accounting for considerable portions of money-market portfolios, negative yields will always be a “clear and present danger.”

That said, all the above risks are well-known and understood. Nothing is new. So, why are we still selling “risk-free” in 2018?