Money Market Funds: Why Your “Plus” Could Become A Minus
by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, May 5, 2008: Issue #792
Last summer my wife and I were shopping for a potential second home in Charlottesville, VA. We quit looking when we decided the prices were too nutty.
(Home prices there have gotten more attractive lately, however. They’ve come down from insane to merely ridiculous.)
Anyway, the money we were planning to use for the purchase I kept in money market funds, specifically the Vanguard Tax-Free Money Market Fund.
“I know a better alternative,” one broker told me. “I have a money market plus fund that will yield more, even after taxes.” I told him thanks but I wasn’t interested…
Do Money Market Funds Need A Plus?
“What’s wrong with a higher yielding money market plus fund?” he asked. “Nothing,” I said. “It’s the ‘plus’ that bothers me.”
As a young man starting out on Wall Street, I confess I learned many lessons the hard way. One is that every financial product with a plus has a corresponding minus. The bigger the plus, the bigger the potential minus.
- You want to own junk bonds instead of high-grade corporates? Expect hair-raising volatility - and occasional defaults - from time to time.
- You want to own stocks instead of bonds? Good idea. But, remember, the trade-off is likely to be occasional sleepless nights.
- You want the even higher potential returns available in companies headquartered in Brazil, India or China? Fine. But expect to go off Niagara Falls from time to time. That’s just the nature of emerging market investing.
Of course, most people don’t expect too many thrills and chills in a “money market plus.” This year, however, Halloween arrived early.
Friday’s Wall Street Journal reports that Charles Schwab is offering settlements to investors in its Schwab YieldPlus Fund, advertised as “a vehicle for conservative investors looking for a slightly higher yield while preserving their capital.”
So far this year the fund is down 26%.
Some investors are wondering what the heck happened…
A Money Market Breakdown - Funds vs. Plus Funds
Here’s a breakdown about the differences between money market funds and money market plus funds.
Money Market Funds:
- Generally invest in high-quality, short-term securities with minimal credit risk.
- They pay dividends that fluctuate, reflecting what is happening with short-term interest rates.
- According to the Investment Company Institute, approximately $3.4 trillion was invested in money markets at the end of last week. (Stock funds, by comparison, hold roughly $6.5 trillion.)
Money Market Plus Funds:
- Are also known as a “ultra-short-term bond fund,” these are a different animal. They are “enhanced cash” products.
- Enhanced cash funds are typically not registered with the SEC and seek higher yields than money market funds. Unfortunately, Milton Friedman was right. There is no free lunch.
- To earn these higher yields, enhanced cash funds exceed the SEC rule restrictions on money market funds governing the credit quality, diversification, and maturity of investments.
Why Schwab’s YieldPlus Money Market Fund Tanked
In Schwab’s case, YieldPlus bet heavily on mortgage-related securities. When those securities tanked, so did YieldPlus.
Schwab has offered a settlement to investors, who had more than $13 billion invested in the fund at its peak last year. But the offer amounts to pennies on the dollar.
Schwab isn’t the only company to experience this problem, incidentally. Other major Wall Street firms have paid millions to settle similar class-action suits.
The lesson here? Higher yields always come with higher risks. Always.
Long-term bonds can get creamed while short-term bonds hold steady. Junk bonds can default while Treasuries rally.
And the “plus” in your money market plus fund? Read the prospectus. Some day it just might turn into a minus.
Good investing,
Alex
Today’s Investment U Crib Sheet
No investment comes without risk. But there are a few risks unique to income investing…
- Credit risk involves the possibility that an issuer will default, or fail to make scheduled payments.
- Income risk is the possibility the income of the fund will fluctuate due to changing rates.
- Reinvestment risk involves the lack of being able to find suitable sources to reinvest funds as they come due.
- Interest rate risk is the possibility of decreasing value due to rising interest rates.
In the declining interest rate environment we’ve been in recently the interest rate risk is next to nothing. However, on Wednesday Ben Bernanke signaled that the rate cut would be the last and that we could expect rates to start increasing.
Investors who are locked into rates will see their holdings drop, as the short-term rates get better than long-term rates.
Currently, here are the average short-term rates:
- 1-year CD - 3.01%
- Money Market Accounts - 2.26%
- Interest Checking - 1.63%
- 6-month Treasury Bills - 1.67%
Money market funds are appropriate for the cash portion of a diversified portfolio, individuals needing the funds in a 1-6 month timeline, or those who require immediate liquidity.
The Vanguard Federal Money Market Fund (VMFXX) is one the nation’s highest yielding money markets. For more income ideas, see Investment U Issue #779, Exchange Traded Funds: 4 Ideas For Income Investors. Alex recommends four exchange-traded funds for investors seeking safety, and those looking for greater returns.
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Related Articles:
- Investing In Municipal Bonds… The First No-Brainer of 2008
- Closed End Funds… The Only Funds That Go “On Sale”
- Junk Bonds: Why One Man’s “Junk” Is Another Man’s Treasure
16 Responses to “Money Market Funds: Why Your “Plus” Could Become A Minus”
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August 6th, 2008 at 3:48 pm
[...] Money Market Funds: Why Your “Plus” Could Become A Minus [...]
August 22nd, 2008 at 3:35 pm
[...] Portfolio
October 9th, 2008 at 10:04 am
[...] Friday, the Treasury Department announced that the government for the first time would insure money market funds to discourage investors from pulling trillions of dollars out and creating financial chaos in the [...]
October 9th, 2008 at 10:36 am
[...] much of the mortgage market and many banks sets a bad precedent. And the plan’s insuring of money-market funds guarantees managers taking more risks will climb and the due diligence of the buyers will fly out [...]
October 13th, 2008 at 2:51 pm
[...] money to work today? With real estate caught in a death spiral? In bonds that pay less than 5%? In money markets yielding [...]
October 21st, 2008 at 11:17 am
[...] By no means am I suggesting all the funds are immune to losses. No investments are. Not even money market funds. [...]
November 3rd, 2008 at 10:39 am
[...] money to work today? With real estate caught in a death spiral? In bonds that pay less than 5%? In money markets yielding [...]
December 2nd, 2008 at 12:02 pm
[...] risk with auction rate securities. Unfortunately, few investors knew how much, or how their money market “plus” could turn into a minus. It’s always the “plus” that adds the [...]
February 6th, 2009 at 10:11 am
[...] will need to put away in your own financial bunker. I suggest putting it into a special savings or money market account. Somewhere that you can get to it when you need it, but not somewhere that you will be [...]
February 10th, 2009 at 10:24 am
[...] shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds is equal to 74% of the market value of U.S. companies, the highest ratio since 1990, according to [...]
February 17th, 2009 at 12:07 pm
[...] shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds is equal to 74% of the market value of U.S. companies, the highest ratio since 1990, according to [...]
April 9th, 2009 at 8:51 am
[...] in cash may have noticed that in less than two weeks the Dow has delivered a greater return than a money market fund compounding at current rates for more than two [...]
April 9th, 2009 at 9:02 am
[...] shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds is equal to 74% of the market value of U.S. companies, the highest ratio since 1990, according to [...]
May 7th, 2009 at 8:47 am
[...] Friday, the Treasury Department announced that the government for the first time would insure money market funds to discourage investors from pulling trillions of dollars out and creating financial chaos in the [...]
May 7th, 2009 at 10:16 am
[...] money to work today? With real estate caught in a death spiral? In bonds that pay less than 5%? In money markets yielding [...]
May 7th, 2009 at 10:27 am
[...] By no means am I suggesting all the funds are immune to losses. No investments are. Not even money market funds. [...]