Four-Month House Payment: Money Market vs Income Fund
A 34-year-old salaried investor in Karachi has PKR 1,500,000 set aside for a house down payment due in exactly four months. The money is currently in a bank savings account earning 5.5% annual profit, paid monthly. The investor is comparing two SECP-registered open-end funds: a money market fund with a gross yield of 10.5%, total expense ratio 0.40%, front-end load 0.25%, and redemption settlement in one business day; and an income fund with a gross yield of 11.2%, total expense ratio 0.85%, modified duration 2.8 years, front-end load 0.50%, and an exit load of 0.50% if redeemed within 90 days. Income fund redemption proceeds settle in two business days. The investor has no other emergency fund and cannot delay the house payment. The investor's marginal tax position is the same for both funds, so ignore tax. Assume the yield curve is flat and any rate change occurs immediately after investment. Ignore convexity.
1. Calculate the expected four-month net proceeds from each fund if yields remain unchanged. Use annualized net yields after expense ratios and include the front-end load. State which fund produces more money.
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Money market fund:
- Net yield = 10.5% - 0.40% = 10.10%.
- Four-month growth = (1.101)^(1/3) - 1 = 3.26%.
- Amount invested after 0.25% load = 1,500,000 x 0.9975 = 1,496,250.
- Expected value = 1,496,250 x 1.0326 = about 1,545,020; net gain about 45,020.
Income fund:
- Net yield = 11.2% - 0.85% = 10.35%.
- Four-month growth = (1.1035)^(1/3) - 1 = 3.34%.
- Amount invested after 0.50% load = 1,500,000 x 0.995 = 1,492,500.
- Expected value = 1,492,500 x 1.0334 = about 1,542,350; net gain about 42,350.
- The 0.50% exit load does not apply because four months is longer than 90 days.
The money market fund produces about PKR 2,700 more on the same starting amount. The result is driven by the income fund's higher front-end load and higher expense ratio, which offset its slightly higher gross yield over such a short period.
2. Assume yields rise immediately by 100 basis points in a parallel shift after investment. Recalculate the income fund's expected four-month proceeds using modified duration. Recommend which fund to use and explain the role of the exit load.
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Approximate income fund price change = -modified duration x change in yield = -2.8 x 1.00% = -2.8%.
- Period income return before price change = 3.34%.
- Net period return after price change = 3.34% - 2.8% = 0.54%.
- Value = 1,492,500 x 1.0054 = about 1,500,560; net gain about 560.
- If redemption happened within 90 days, the 0.50% exit load would reduce the value further to about 1,493,060, roughly a PKR 7,000 loss versus the original investment.
The money market fund remains at about PKR 1,545,020 because its duration is very short, so its price is much less sensitive to the rate rise. For a payment that must be met in four months, the money market fund is the suitable choice. The income fund's extra yield does not compensate for the duration risk when the holding period is shorter than the fund's modified duration. The exit load is mainly a discipline on early redemption; here it is not triggered, but it would matter if the house payment date moved earlier.
3. Suppose the house payment is delayed to 18 months and the investor accepts a small chance of principal loss. How would the recommendation change? Identify at least two additional risks to check before switching.
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With an 18-month horizon, the income fund has more time to earn its higher net yield and to recover a duration loss. A 100 bp rise would cause about a 2.8% price fall, which is roughly 3.2 months of net yield at 10.35% annual, so an 18-month hold is more forgiving. However, the front-end load difference still matters: over 18 months, the extra 0.25% load is about 0.17% per year, small relative to the yield difference. The choice is therefore closer, but it is still not automatic: if the payment date is fixed and the investor cannot tolerate a shortfall, the money market fund remains safer. Before switching, check the income fund's credit quality and any lower-rated holdings, its average maturity and concentration, its redemption terms and exit-load period, and whether secondary market liquidity could delay settlement. Also check whether the fund's distribution policy could change. A reasonable compromise is to keep the down payment in the money market fund and invest only a small surplus in the income fund.