Money market funds can cost your investment

“A significant number of investors choose to add a money market fund to their investment portfolio for the deduction of fees and income, as opposed to deducting these amounts proportionally from all the funds,” explained Lloyd.
 
Deducting fees and income from a money market fund
 
A multi-asset fund contains a combination of asset allocation funds in order to match the risk profile of the client. By adding a money market fund or an income fund, you are essentially adding a cash component to the investment, and therefore reducing the risk level of the portfolio.
 
“It [is] important to remember that the majority, if not all of the underlying funds in the portfolio, will already have a cash and/or income component. So by increasing this you are reducing the exposure to risky assets at the same time,” explained Lloyd.
 
In order to counter this, Lloyd suggested that the income and fees be proportionally deducted from all of the funds within the portfolio. “On the other hand, if you are set on having a money market or income fund for this purpose, then it’s important to increase (depending on your allocation to a money market or income fund) the risky asset exposure in the portfolio to make up for the “de-risking” effect of adding such a fund.”
 
Lloyd said: “If risky assets outperform fixed interest assets over the long term, the returns produced by the money market fund should be lower than the returns produced by the funds with exposure to risky assets.  This return differential over time, thanks to compounding, will result in the portfolio with a money market fund (from which income and fees are deducted) underperforming the portfolio where income and fees are deducted proportionally.”
 
Building block portfolios
 
However, if you are making use of a building block approach to your portfolio, rather than a multi-asset fund approach, it is better to deduct fees and income from the cash portion of the investment.
 
A building block approach to investing has a cash or money market component to it already. Here, Lloyd noted, it would make sense to deducting the fees and income from the cash portion of the portfolio.
 
This is because, by deducting the fees and income from the cash portion of the portfolio, you are reducing the exposure to the cash component, which in turn increase the risk level of the portfolio.
 
“If an investor has a building block portfolio and they decide to deduct the fees and income from the portfolio’s cash component, they will in essence be increasing the overall risky asset exposure in the portfolio.  And if risky assets outperform fixed interest assets over the long term this strategy would outperform the building block portfolio where fees and income are deducted proportionally from all the funds,” explained Lloyd.
 
He highlighted: “If you have a multi-asset fund portfolio, you should consider taking your income and fees proportionally from all the funds. If on the other hand, you decide to follow a building block approach, then you may be better off deducting both the income and fees from the portfolio’s cash portion and not proportionally from all the funds.”