Time to dust off money market funds

Your Funds

July 31, 2005|By CHARLES JAFFE

IN THE NEXT week or two, the yields on some of the biggest money market mutual funds will top 3 percent.

That should be enough to get some investors excited about money funds again.

In-flows into the safest form of mutual fund have picked up recently, as the Federal Reserve Board's spate of interest rate increases created a fivefold gain in the yield of the average money fund. Average taxable money funds now sport their best yield since the fall of 2001, at roughly 2.7 percent; top performers already are north of the 3 percent line.

"There is no secret to money fund yields; take the Fed funds target and subtract a half-point expense ratio," says Peter Crane, managing editor at imoneynet.com, which tracks money fund yields. "A year ago, money funds paid just under a half percent, and now the average rate is just under 2.75.

"But with the Fed likely to raise rates two or three more times this year, you're looking at the average money fund ending the year with a yield of about 3.5 percent. From where rates were, that's huge."

It's also better than the return in a three-month certificate of deposit in a bank - and about the same as the average six-month CD - which is why safety-conscious savers have taken notice.

"It could pay to watch the money funds because their yields will continue to rise as the Fed raises short term rates," says Greg McBride of BankRate.com. "Yields on short-term CDs won't keep pace if the flat yield curve handcuffs banks on paying higher returns. ... From a rate and a comparison standpoint, money funds are likely to get more attractive in the next few months."

Few people expect to get rich loading up with money funds, but safe-and-boring with a reasonable return is a good bet for the cash portion of a portfolio.

Because it is easy to ballpark the likely return - see Crane's formula above - the key is finding a fund that captures as much of the gross gain as possible.

When interest rates were next to nothing, many firms waived all expenses on their money funds to ensure that the return did not go negative. When rates started rising, many companies reinstated their costs, effectively taking the first two or three rate increases for themselves and leaving shareholders in the cold.

For investors looking to get back into money funds, or to goose the yield they are getting from a current fund, the good news is that picking a money fund is simple.

Start by following human nature and look for issues with the highest current yields.

This runs against conventional wisdom for stocks and bonds, where the typical warning involves shunning hot funds to avoid the potential for an overnight turnaround.

You can use a list of top current earners because the rules governing money funds make it so that virtually all are created equal. Typically, what separates a top money fund from the average is the amount of expenses charged to investors.

In a reasonable rate environment, waiving expenses is typically the way a fund firm attracts new money. Over time, however, many firms turn up the heat on that cash, raising fees toward the norm and hoping investors don't notice and stay put.

That means today's top fund could be in the middle of the pack tomorrow if management discontinues a fee waiver, which is why yield-hungry investors should consider dumping any money fund that drops down the charts.

Money funds offer three key features: liquidity, safety and yield.

If safety is paramount, for example, the right choice could be a fund that is 100 percent invested in Treasuries; tax considerations may factor into the best type of fund to buy, too.

Most money funds have check-writing privileges, making them a potential substitute for a checking account. Unlike bank accounts, money funds are not insured against loss.

Charles Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or at Box 70, Cohasset, Mass. 02025-0070.

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