Want Stability? Hate Risk? Try Money Markets

People don’t raise their children to manage money market funds. There’s nothing particularly glamorous about the job.

Yet these professionals may be the unsung heroes of the investment world. Money fund managers and the mutual fund companies they work for have achieved a remarkable record of success. Perhaps more than any other financial asset, money funds have delivered what they’ve promised: competitive short-term yields for smaller investors, with virtually no risk of loss. And this enviable safety record has come about without federal insurance.

It’s debatable whether a money market portfolio has ever lost money. Critics point out that a small fund declined by 6 cents a share in 1978. But William Donoghue, publisher of Donoghue’s Money Letter in Holliston, Mass., contends that the infamous portfolio wasn’t a true money fund because it had an average maturity of 20 months.

By definition, money funds invest in short-term debt--anything coming due in less than one year, but more typically within four months. The less time until a debt obligation matures, the less likely the issuer is to get into financial trouble. There’s also less time for rising interest rates to cause havoc.

Occasionally, a short-term debt issue will default; it has happened several times over the past year. In each case so far, fund companies reached into their own pockets to make shareholders whole and safeguard the reputation of money funds.

At any rate, money market portfolios typically diversify across dozens if not hundreds of debt instruments issued by large corporations, banks, municipalities and even the federal government. It all adds up to a high degree of safety.

“From a risk point of view, it’s probably not necessary for an investor to hold more than one money market fund,” says Michael Hines, vice president of marketing for Fidelity Investments in Boston. However, there’s no significant reason not to hold two or more money funds, especially if you’re worried about safety.

Many people wind up with more than one money portfolio anyway because they’re attracted to mutual funds offered by more than one company. Above all else, money funds make sense as havens for cash during treacherous periods in the stock and bond markets.

In fact, your choice of a money market portfolio should largely depend on the selection of stock and bond funds that you can switch into and out of. “Above all else, find a fund family with equity and bond products you like,” suggests Ron Rough, assistant vice president of research at Schabacker Investment Management, a Rockville, Md., firm that specializes in mutual funds.

Although money market portfolios pay different yields, the variances are slight--usually within half a percentage point for a given type of fund, Rough says.

Larger money funds tend to offer somewhat higher yields than their smaller counterparts due to economies of scale. Conversely, portfolios with above-average costs usually pay less. “Expenses, or the lack thereof, determine the top yields,” Rough says.

And, of course, yields depend on the quality of assets held. Treasury bills and other government securities face the lowest risk of default and thus tend to pay slightly less than, say, short-term corporate debt (“commercial paper”), which accounts for about 50% of all money fund assets. The Securities and Exchange Commission recently proposed that money funds be required to invest at least 99% of their assets in top-rated securities.

Money fund yields mirror short-term interest rates in general and thus fluctuate all the time. Investors naturally try to find portfolios that pay the most.

Just be careful to compare apples to apples. Not all money funds pay interest that’s subject to taxation. Some skirt federal taxes while others avoid state taxes. Still others--the “single state” money funds--pay interest that’s free of both state and federal levies.

The various tax-exempt funds offer lower nominal yields than their taxable counterparts. The former group recently paid an average yield of 5.28%, according to the Donoghue Organization, compared with 7.67% for the latter.

Which is better? That depends on your income level. If you fall within the top federal bracket of 33%, the recent 7.67% taxable yield equals an after-tax return of 5.14%. In this case, the tax-exempt money fund would make a slightly better bet. But if you fall in the 28% bracket, the taxable money fund would offer a superior yield. Keep in mind that the relative rates paid change all the time.

Donoghue suggests a third approach for residents of high-tax states such as California. His choice: money market funds that invest strictly in Treasury bills and other short-term U.S. government debt. California and other states don’t tax the interest paid by federal securities (although Washington itself does). This increases the effective yield for in-state investors.

Donoghue favors three such portfolios: the Benham Government Agency, (800) 4-SAFETY; Dreyfus U.S. Guaranteed, (800) 645-6561, and Fidelity U.S. Treasury, (800) 544-6666, money market funds. Recently, each paid a compound yield of 8.3% or better, none of which is subject to state income taxes.

And, as noted, government securities are virtually risk-free. “Everything else being equal, I’d rather be in a portfolio of Treasury bills,” says Donoghue.

Besides yields that in many cases exceed what you can get at banks, money funds have other attractive features. These include:

* Liquidity: You can withdraw cash from a money fund at any time. To make this easier, the funds offer check-writing privileges. However, most prohibit you from writing checks for less than a minimum amount--usually $200 to $500, Donoghue says. Certain funds will return your canceled checks but others won’t. Some also offer the use of a credit card.

* Low minimum investments: You can open a money fund account for almost any amount. A few funds require $5,000 or more, but most fall in the minimum range of $1,000 to $2,500. A handful accept investments of $100 or less.

* Switch privileges: In most cases, you can quickly transfer assets from a money fund to a stock or bond portfolio, or back. Many companies let you do this over the phone.

Clearly, money market portfolios offer a pretty good deal. And the word has gotten out. These investments account for 37% of all mutual fund assets. Bond and income portfolios account for another 37%, and stock funds 26%.

Unfortunately, you won’t get rich off money market securities. They simply don’t offer the growth potential of equities or even bonds. At best, money fund yields will stay ahead of inflation by only a couple of percentage points.

That’s why it doesn’t make sense to tie up your investment dollars in money funds for the long term.

A FAMILY MATTER Investors typically focus on high yields when shopping for money market portfolios. But unless you plan to keep your cash tied up in a money fund indefinitely, you also need to look at the stock and bond portfolios offered by a fund family.

The table below lists the highest-yielding taxable money market portfolios at some of the better mutual fund companies, as defined by the Donoghue Organization. Each family offers a variety of stock and bond funds.

Recent Minimum Money fund yield investment Phone number Cash Equivalent Gov’t Securities (Kemper) 8.1% $1,000 (800) 621-1148 Dreyfus Worldwide Dollar 8.8% $2,500 (800) 645-6561 Fidelity Spartan 8.6% $20,000 (800) 544-6666 Neuberger & Berman Cash Reserves 8.0% $2,000 (800) 877-9700 Scudder Cash Investment 7.9% $1,000 (800) 225-2470 SteinRoe Cash Reserves 7.9% $1,000 (800) 338-2550 Strong Money Market 8.2% $1,000 (800) 368-3863 T. Rowe Price Prime Reserve 7.8% $2,500 (800) 638-5660 Twentieth Century Cash Reserve 7.7% None (800) 345-2021 Vanguard MMR Prime 8.4% $3,000 (800) 662-7447

The Donoghue Organization publishes an eight-page report that ranks money market portfolios using a variety of criteria. For a copy of this free “Top Money Funds” report, write to the group at: Box 6640, Holliston, MA 01746, or call (800) 445-5900.