The Fed has aggressively raised rates during since early 2021 to combat inflation and slow down the growth of the economy. This action has put upward pressure on interest rates of all maturities which therefore decreased bond valuations. At the same time, there is a silver lining to this elevated interest rate environment. One benefit we have witnessed is the higher yields that have been recently experienced in money market funds.
Many money market funds are currently yielding over 4.75% (as of July 2023). These funds tend to be bought and sold like mutual funds and priced at $1.00 per share. They are typically used as alternatives to holding cash. In contrast to savings accounts which earn a rate from the bank, these funds invest in short-term debt instruments to earn a higher yield. An attractive benefit of these funds is they don’t have the same price valuation fluctuations as other debt instruments, but their interest rate is variable.
With rates as high as they currently are and after our investing experience in 2022, many investors have shown a renewed interest in these funds. At the same time, we must be aware that despite their elevated returns, we do not expect them to build wealth over time because their returns have historically been close to the long-term inflation rate.
To demonstrate, we will compare returns over time. The One-Month Treasury Bill is used as a proxy for money market returns as their risks/returns are comparable. For inflation, we will use the U.S. Consumer Price Index as a proxy (specifically the Consumer Price Index for All Urban Consumers). Both measures have data going back to January 1926.
From 1926 to 2022, the average return from the One-Month Treasury Bill only differs by about one quarter of a percent.
To view the effects of this return difference, we can illustrate how a dollar invested might have grown if these returns were experienced over the same period. The graph on the following page shows this relationship:
One way to interpret this graph is to understand that one dollar in 1926 has the same “purchasing power” as $17 in 2022, due to inflation. In other words, what cost a $1 in the 1920s would now cost $17. In comparison, if you were to have invested the original $1 in One-Month Treasury Bills over the 96-year period, you would only have $5 of gains above what was eaten away by inflation.
Although current money market rates appear high compared to what we have seen in recent years (but certainly nowhere close to the 1970s), we don’t expect these funds to be growth engines of a portfolio.
For comparison purposes, to show the power of long-term investing, we included what $1 would be worth today if it was originally invested in the S&P 500 Index – Over $11k!
While we don’t expect real long-term growth from money market funds, they can help curb the effects of inflation on cash holdings. Money market funds can also be used as a store of value while an investment plan is being developed, modified, or implemented. For long-term investors looking to create wealth, we continue to recommend a globally diversified portfolio of stocks and bonds, in line with an investor’s risk profile.
Note: Money market funds do not have the same guarantees as bank deposits (no FDIC insurance), but they are highly regulated and the instances of monetary loss of investors from these funds has been extremely rare. Their yields are also variable in nature and can decrease.