Why Use Money Funds at All?

Money market funds are a zombie investment. So why does anyone invest in these funds – one of the most important tools for savers over the past several decades, and now essentially among the walking dead? Because, despite their tiny interest payments and many other disadvantages, money funds seem relatively safe.

How unfortunate that an investment holding $2.6 trillion has eroded so much (down from the peak of $3.8 trillion in 2008). And how odd that these funds still hold as much as $2.6 trillion. What was once an important vehicle for cash management is now a nearly useless receptacle for savings. Money funds invest in Treasury bills and commercial paper, which today pay rock bottom rates.

According to Money Fund Report, the annual yield on retail (that is, meant for individuals, not institutions) money market mutual funds is 0.01 percent. One hundredth of one percent. That’s very little incentive to use something other than an old coffee can to store your savings.

Given short-term interest rates, which the Federal Reserve and regulatory changes keep on the floor, there is essentially no return available. In 2010, the Securities and Exchange Commission limited the types of investments money market funds can own, requiring funds to keep a significant amount in shorter maturities (which pay less) and higher-quality instruments.

These rules resulted from the 2008 travails of the landmark Reserve Primary Fund, which invested heavily in nicely yielding commercial paper from Lehman Brothers. When Lehman went bust during the financial crisis that year, the Reserve and other money funds almost went under. A federal bailout saved them.

Even under better economic conditions, money market funds are not likely to return to the days of paying attractive interest – at least for quite some time. Money market fund reform that the SEC will implement over the next two years will make them more transparent, although not any better from a return standpoint.

What to do with your cash has become a significant money management problem. Inflation, which at 1.7 percent is higher than short-term yields, chews away at your interest income. Whether your cash is in a money market mutual fund, a (relatively speaking) high-yield online bank savings account, certificates of deposit or Treasury bills, savers are punished with a negative real return. All of these cash management vehicles have for quite awhile now, paid out interest at a rate much lower than inflation.

Building up savings to better manage your financial situation is actually costing you money, due to the diminished purchasing power of those dollars. Low interest rates allow the government to borrow money at a tremendous value, compared to historical rates, but they essentially create a hidden tax on savers.

Cash-equivalent investments are at the foundation of any well-designed financial plan. They have served many purposes without a complex structure. They may be the boring part of a financial plan but are generally safe and meant to provide some reward for building cash reserves or saving for an upcoming goal.

To generate much income at all, let alone keep up with inflation, many savers are forced to climb the risk ladder to invest in investment grade bonds yielding 3 percent to 3.5 percent, or even junk bonds (averaging just over 6 percent), which have less certainty of protecting principal. These reaches for yield aren’t much of a problem for some investors, but it does introduce the need to scrutinize the risks they take and the probability of permanent loss. This is something new for people used to Federal Deposit Insurance Corp. guarantees on their bank savings. Money funds don’t get FDIC backing, although as 2008 showed they appear too important to fail.

Thus, despite microscopic returns and inflation’s corrosion, money fund investors appear to be relatively safe. Once the Fed does increase interest rates, possibly not for another year or more, the value of many types of bonds will suffer – rates and bond prices move in opposite directions. Yet in a money fund, at least the principal’s value won’t be harmed once rates rise.

Here’s a zombie investment defense kit.

First, determine your requirement for cash. How much liquid money do you need over the next 24 months? Keep in mind that even someone with a well-managed budget and a steady job should keep at least three months worth of expenses in cash. And if you have a big-ticket expense in the near future, the money allocated for it shouldn’t be exposed to market risks.

The best current option for your required cash is an online savings account. They are easy to set up and link to your checking account for movement back and forth. They are available with no fees, no minimum dollar amount or holding period and they are FDIC-insured. Capital One, HSBC and others currently pay 0.75 percent or better annual percentage yield. It may still trail inflation but is many times better than money market fund offerings. CDs are another option. Even if you have to cash in a CD before maturity, the penalty (usually three months interest) is not a significant one.

Once you’ve got enough set aside for your emergency fund, there may not be much reason to keep an allocation to cash in your investment portfolio. Especially if your investment mix is liquid and well diversified, you may find it just fine to stay more fully invested, perhaps overweighting your typical allotment to short-term high-quality bonds.

Unfortunately, however, the days of the risk-free 3 percent return on your cash are long gone and may not return for a long time.

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Written by Gary Brooks, a certified financial planner and the president of Brooks, Hughes & Jones, and a registered investment adviser in Tacoma, Wash. Find risk tolerance resources at his blog The Money Architects.

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