Vanguard Funds: The One Mutual Fund That's Hotter Than a Hedge Fund

Alexander Green
by Alexander Green, Chief Investment Strategist

Vanguard Funds: The One Mutual Fund That's Hotter Than a Hedge Fund

by Alexander Green, Chief Investment Strategist

Friday, May 18, 2007: Issue #675

I made my first brilliant investment in 1981.

That was the year I walked into Flagship Bank - which was later bought by Barnett Bank, which was later bought by NationsBank, which was later bought by Bank of America - and opened a checking account.At the time, Fed Chairman Paul Volcker was a man possessed. He was determined to snuff out inflation no matter how high rates had to go. And, eventually, he got the job done.

No, it wasn't a free toaster that made this feel like a stroke of genius. It was the fact that Flagship was paying money market interest rates on new checking accounts. And money market rates were near an all-time high - 16%.

In the meantime, earning 16% on my money with no stock or bond market risk seemed like a terrific idea. After all, stocks and bonds were going nowhere except down.My brilliant investment paled considerably in the luxury of hindsight.

However, it wasn't long before the glory - and high returns - began to fade. Interest rates started coming down - fast. And, needless to say, so did the yield on my Flagship money market fund.

Meanwhile, stocks and bonds - which had been beaten to a pulp while rates were going up - began to lift off in earnest. And wouldn't peak for nearly 19 years. (26, if you don't mind riding out a couple bear markets.)

Today the situation is quite different. According to Crane Data, a research firm, the average yield at the 100 largest money market funds is 5%. Yet money is pouring in anyway.

You think hedge funds are hot? They can't hold a candle to the cash inflow at money market funds right now. And in today's issue, we'll review Vanguard Funds some of the best in the business right now. But first, let's look at the pros and cons of investing in money market funds

Piling $600 Billion Into Money Market Funds

Money markets funds currently hold over $2.4 trillion in assets. And recent growth has been impressive. Investors have piled a fresh $600 billion into these funds over the last two years.

Is this a smart thing to do? Yes and no.

  • Yes, if you have a specific short-term saving goal in mind, like accumulating a down payment on a house or paying next fall's college tuition.
  • Yes, too, if you're weighing the advantages of cash vs. short-term bonds. Right now you can earn only 4.65% in two-year Treasury notes and 4.69% on 10-year Treasury bonds. So you actually earn a higher yield by taking less risk. (So much for the old chestnut about risk and return going hand in hand.)

Of course, there's also my experience at Flagship Bank to consider. What if short-term rates start come down?

Then money market yield will drop - and stock and bond prices are likely to get a lift.

This is exactly the scenario a lot of smart money managers are banking on. For example, Bill Gross, manager of the biggest of all bond funds, the $103 billion Pimco Total Return Fund, predicts the Federal Reserve "will cut rates and cut them significantly over the next few years in order to reinvigorate an anemic U.S. economy."

Ian Sheperdson, chief American economist at High Frequency Economics in Valhalla, NY, agrees. He expects the Fed to cut its target rate on overnight bank loans - the fed funds rate - to 3.75% by March of next year. If he's right, money market yields will drop from 5% to about 3.25%.

But are these Fed bulls right? That's the $64 million question.

Unfortunately, my crystal ball is in the shop this week. So I suggest you hedge your bets. Keep some cash in money markets and spread some out in a laddered portfolio of bonds, too.

Vanguard Mutual Funds... The Best Money Market Funds Today

A cheap and easy way to do this is with Vanguard mutual funds. You can use, for example, the Vanguard Short-Term Investment Grade Bond Fund (VFSTX) and Vanguard Intermediate-Term Investment Grade Bond Fund (VFICX). (For more information visit Vanguard.com or call 800-662-7447.) Vanguard offers low minimums, rock-bottom expenses and monthly dividend reinvestment.

The Vanguard Prime Money Market Fund (VMMXX) isn't a bad place for your cash either. According to Bankrate.com, it's the nation's highest-yielding money market fund, with a current 7-day yield of 5.23%.

The Vanguard Tax-Exempt Money Market Fund (VMSXX) yields 3.86%. If you're in the 35% tax bracket, you'd have to earn over 5.5% taxable to top it.

Money market funds aren't sexy, I know. And if the Fed starts cutting rates later this year, the yields won't look so hot either.

But if you have cash sitting around in a local bank or brokerage account, my guess is you're probably earning roughly half what the Vanguard funds are paying. Perhaps less. As the weeks slip by, you may be leaving an awful lot of cash on the table.

So it's worth making a phone call to see what you're getting paid. Just tell them the folks at Flagship sent you

Good Investing,

Alex

Today's Investment U Crib Sheet

Money market funds invest in short-term securities with maturities of less than one year. The holdings in the Vanguard Prime Money Market Fund, for example, have an average maturity of 65 days. Right now, 56% of the fund's $85 billion in assets are invested in Certificates of Deposit, and another 37% are invested in commercial paper and U.S. government debt. And while most money market funds are open-ended mutual funds, and aren't FDIC insured, they are one of the safest places to park your cash

Moody's gives 96% of the securities in Vanguard's Prime Money Market Fund a rating of "Aa1" or better. (See Moody's ratings scale.)

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