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How do foreign money market funds work?
Q: Can a foreign money market mutual fund purchase American commercial paper?
A: That question can be approached two ways:
- If you are referring to a U.S.-based fund whose mandate is to invest in foreign securities, then the answer lies very much in the details of the prospectus. Even with a foreign investment mandate, a U.S. fund may have some latitude to invest in domestic commercial paper for liquidity purposes or for tactical investment reasons.
- If you are referring to a fund based in a foreign country, the answer would depend on both the laws of that country and the latitude of the mandate. Before you invest in any kind of fund based in another country, you should make yourself aware of how that country's investment laws differ from those of the U.S.
In either case though, there are a number of things an investor should consider in this type of situation:
- Read the prospectus -- labels can be deceiving. Mutual funds can be named for a type of investment that is the fund's primary emphasis, but the investment objectives of the fund might give the manager substantial discretion to invest elsewhere. It is important to go beyond the title and read the prospectus to see just how much latitude the fund has.
- Scour the annual report. The annual report should contain a list of holdings, so you should review this for any fund you own to see if those holdings match your understanding of the investment approach.
- Consider currency risk when investing for income. Foreign income yields can look much more attractive than domestic ones, but often a high yield is a sign of a weak currency. Fluctuating exchange rates not only can negate the yield advantage you are seeking by investing in foreign securities, but it can also make the fund's yield much more erratic than you might expect from an income investment.
- Pay particular attention to fees in income funds. High-quality U.S. commercial paper yields are running between nearly zero and about a quarter of a percent. With yields so low, you need to make sure that fees won't wipe out the lion's share of a fund's income.
- Do not mistake money market funds for money market accounts. Money market accounts held at a U.S. bank carry the deposit insurance backing of the FDIC. Money market mutual funds, whether invested in U.S. or foreign securities, are not covered by the FDIC.
One of the dangers a low interest rate environment creates is that even conservative investors find themselves taking on extra risk in an attempt to find higher yields. That may be necessary, but it is important to understand the risks you are incurring.
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