Money Markets Still Add Up in Specific Cases

This is not the best of times for money market funds. With yields down to their lowest levels in years, a lot of people must be wondering whether these investments still make sense.

They do.

It’s just that you might have to alter your thinking about what the securities are supposed to accomplish.

Money funds are designed to serve as safe, short-term parking places for cash, yet many people seem to leave their assets there on a more or less permanent basis. A lot of investors probably keep too much cash in money funds, especially for long-term goals such as retirement planning.

For example, at last count, money market portfolios had 24% of all the mutual fund assets held in individual retirement accounts, compared to 46.5% for equity funds and 29.5% for bond funds, according to the Investment Company Institute. Yet some advisers recommend keeping substantially all of your long-term assets in riskier funds, because they offer much better potential over time.

Overall, a record $490 billion is parked in money funds, reports the ICI.

As long as money market portfolios offered yields of 7% or 8% and up--as they did as recently as 1990--investors could get away with keeping their long-term holdings in the funds. Now, with average yields around 4.5%, people are realizing the dangers of being too cautious.

Ever since money funds were introduced 20 years ago, their main role was as a place to park assets for an imminent need of cash or as a shelter during tumultuous periods in the stock or bond markets.

“A lot of the money that poured into money funds in the early ‘80s probably shouldn’t have been there in the first place,” says Don Phillips, publisher of Morningstar Mutual Funds, a Chicago research publication. “People got hooked on something that couldn’t last indefinitely.”

The money fund returns of the past decade had been abnormally high compared to what Treasury bills--the benchmark for short-term, cash-equivalent investments--have historically delivered.

Stretching back to 1926, Treasury bills have achieved only a 3.7% average annual gain, just a shade above the 3.1% average inflation rate over the same stretch, says Ibbotson Associates, a Chicago research firm.

In other words, cash-equivalent investments, including money funds, were never intended to make anybody rich.

What the funds are supposed to do is offer a combination of safety and easy access (liquidity), while paying yields competitive to what’s available with other short-term investments.

If anything, experts say, money funds are even safer than they were a year ago thanks to reforms, mandated by the Securities and Exchange Commission in 1991, that tighten the requirements on what money funds can and can’t hold.

“Money funds are intensely regulated, and it’s one example of regulation for the mutual fund industry that’s good,” says Pamela Weingarten, head of the Los Angeles-based Pilgrim fund group.

Unlike bank accounts, money funds don’t offer federal deposit insurance, and so far it hasn’t been needed. No investor in a true money fund has ever suffered a loss, although a handful of management companies have absorbed setbacks from time to time, rather than pass the losses on to shareholders and sully the funds’ reputation.

Money funds invest in corporate debt, certificates of deposit, Treasury bills and other IOUs of a very short-term nature--typically with maturities of 90 days or less. Because these instruments come due so quickly, the funds usually aren’t materially affected by credit problems or fluctuating interest rates.

Instead, money fund yields soon adjust to prevailing interest rates, leaving the underlying principal value unaltered.

Besides being safe, money funds are convenient. Typically, you can start investing with as little as $500, and you can withdraw your cash at any time without penalty. As with bank products, you can write checks drawn against a money market fund.

The funds are especially good for dollar cost averaging--a strategy whereby you invest in riskier stock or bond funds gradually and in relatively small increments.

For example, you might put $20,000 into the money market portfolio offered by the fund family of your choice, then move $500 or $1,000 into a stock fund each month. This way, you ease into the riskier investment--not a bad idea given the high levels of the stock and bond markets.

Most fund companies offer dollar-cost averaging, usually at no charge.

One result of the recent drop in money fund rates is that investors might be less inclined to shop for funds solely on the basis of yields. With rates compressed across the board, it doesn’t matter as much which money market portfolio you choose. Instead, you can concentrate your efforts on finding the best stock and bond funds.

In addition, the lower short-term yields could mean that investors will be forced to look increasingly at stock and bond funds to fulfill their long-term goals, as they discover that the days of the risk-free lunch in money market portfolios are over.

Diminishing Returns The average returns paid by money market mutual funds fell sharply in 1991 from the previous 10 years. Rates so far in 1992 are even lower--in the range of 4.5% on average for taxable funds.