Higher Yield Means Higher Risk--Unless It’s a Money Fund

You aren’t supposed to get something for nothing, but it sure seems to work that way in the money market mutual fund business.

The Strong Heritage fund, the highest-yielding money fund in the nation, found itself stuck with commercial paper of suddenly fraud-ridden lender Mercury Finance last week. As the value of that short-term paper plummeted, it threatened to erode the Strong fund’s normally stable $1-per-share asset value.

So the fund’s parent, Milwaukee-based Strong Capital Management, quietly stepped up and bought the Mercury paper for full value from Strong Heritage and from two other Strong money market funds that owned some as well.

Strong’s money fund shareholders thus were protected. And had the affair not leaked to the press, shareholders would have been none the wiser--free, in the case of the Heritage fund, to blissfully continue collecting their 5.65% annualized yield, which is far better than the 4.86% yield currently paid by the average money market fund.

If this episode sounds vaguely familiar, it’s because we’ve been here before. Despite their generally sterling reputations for safety, money funds have stumbled into trouble several times in this decade. But fund management companies have nearly always done whatever was necessary to maintain the stable asset value that investors have come to believe is sacrosanct: You put $1 in, you’ll get $1 back, any time. Plus interest.

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Peter Crane, managing editor of IBC Financial’s Money Fund Report newsletter, notes that in 1995, 15 money funds that held Orange County debt bought insurance for that paper during the county’s bankruptcy stint, to maintain the paper’s market value rather than take even a temporary loss on it. In 1994, nearly two dozen money funds--including ones managed by BankAmerica and Atlantic Richfield--were extricated from soured “derivative” securities by their rich parent companies. And in 1990 the failure of Integrated Resources caught other funds unaware, but they, too, made shareholders whole, with little fanfare.

The only exception was an institutional money fund that failed because of derivatives in 1994. Its clients--mostly banks, not Ma-and-Pa investors--got back 94 cents for every $1 invested.

For individual investors in money funds, the lesson seems to be that if your fund puts your money where it shouldn’t have--probably in search of higher yields--the extra risk involved is borne by the management company, not you.

Did the Strong money funds take higher risk to goose their yields? In the eyes of two credit-rating agencies, Mercury paper wasn’t top-tier for safety. But Strong, which won’t say exactly how much Mercury paper it owned, says its funds sport high yields not because of greater risk-taking but because it waives much of the management fee it would normally charge for its funds. In the case of the Heritage fund, for example, Strong’s annual management fee is just 0.11% of assets; it waives the rest, an additional 0.46% fee.

But fee waiving is standard practice among money funds. IBC Financial says 58% of all taxable money funds waive fees in full or part. The idea is that the lower-fee funds act as “loss leaders”--a way to get investors into a fund complex, then lure them into higher-fee stock and bond funds.

Clearly, however, fee waiving doesn’t fully explain the yields of the most aggressive loss leaders. Even so, thanks to Securities and Exchange Commission-mandated rule changes over the last decade, it’s harder and harder even for aggressive money funds to take significant risks. Until 1991, for example, a fund could have 25% of assets in a single security. That general limit now is 5%, and it’s 1% for certain securities.

Strong spokeswoman Jody Lowe says the company’s funds follow SEC rules to the hilt. She also points out that the Mercury case involves fraud--something that’s hard to protect against.

Happily, all of this is academic for money fund shareholders. What Strong proved, like dozens of fund companies before it, is that investors may as well own the highest-yielding money fund they can find, because in defiance of general investment principles there is no extra risk entailed in collecting a higher yield. So long as your fund management firm’s pockets are deep enough, your money fund’s mistakes, if any, won’t cost you. No wonder money fund assets are nearing $1 trillion.

Now, if only we could arrange for things to work the same with stock and bond mutual funds . . .

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Playing to Greed?

Here are the 10 highest-yielding money market mutual funds for the seven days ended Jan. 28.

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7-day Assets Money fund yield* (millions) Strong Heritage 5.65% $2,000 OLDE Premium Plus 5.62 1,750 Strategist Money Mkt. 5.51 NA Kiewit Mutual 5.39 548 Nations Prime/Primary 5.39 2,494 Aetna Money Market 5.36 131 Fremont Money Mkt. 5.35 312 E Fund 5.33 19 McM Principal Pres. 5.33 NA Managers Money Mkt. 5.32 34 Avg. money fund 4.86

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* annualized compound yield

NA: not available

Sources: IBC Financial Data; Lipper Analytical