Money funds come in various types:
- The supersafe. They invest only in U.S. Treasury bills and buy no Treasury derivatives. In general, investors earn less than they would in other funds. An exception could be an investor in a high-tax state such as California, Massachusetts, or New York. Dividends paid by Treasury funds are exempt from state and local taxes. As a result, they may net you more than funds invested in taxable corporate securities, especially if the Treasury fund has low expenses.
- The plenty safe. These mixed funds buy Treasury securities and corporate securities too. They usually yield 0.25 to 0.5 percentage point more than pure Treasury funds, so you’re gaining $12.50 to $25 a year on a $5,000 investment. In my opinion, mixed funds are safe enough. Tax-exempt money funds, invested in short-term municipal securities, are plenty safe too.
- The probably safe. The highest-yielding money funds buy corporate securities and follow slightly riskier strategies. Reserve Primary Fund strayed into this area. So far, it has been the only one to lose money for
investors, but it prob-ably won’t be the last. If you buy a high yielder, be sure that it’s sponsored by a major financial institution that will step in if anything goes wrong.
Regardless of the type of fund you’re interested in, don’t break your neck hunting for the highest payer. There’s always a different name at the top of the list, depending on each fund’s holdings and how fast it responds to daily changes in interest rates. I’d use six criteria in choosing a fund:
1. Are its expenses low? You’ll find the answer in the prospectus, in the table that shows all the fees and expenses. Managers who charge 0.5 percent of assets or less have a good shot at being top performers. Fees of 1 percent or more usually mark the funds that do the worst. Some funds with low expense ratios levy separate service charges, such as $2 per check or $5 per telephone transfer. If those fees were figured into the expense ratio, the fund would show a slightly higher cost. Some funds waive part of their fees temporarily to produce a competitive yield. When fees return to normal, your yield will drop. In general, large money funds are more cost efficient than small ones and ought to cost you less.
2. Does it fit your purse? You should have no problem meeting the fund’s minimum balance and check-writing rules.
3. Is it handy? If you invest with a particular mutual fund group or stockbrokerage firm, you’ll probably use the firm’s own money fund as a place to park cash.
4. What’s the fund’s average maturity—meaning, how long does it take for its average investment to come due? The shorter the term, the less risk the fund takes. Under proposed SEC rules, average maturity generally can’t exceed 60 days. (An average of 75 days is also under discussion.) Most funds post even shorter terms.
5. Does the fund belong to a major financial organization—a mutual fund group, a large brokerage house, an insurance company? This is your equivalent of deposit insurance. So far, these money fund sponsors have always paid for their mistakes rather than saddle their shareholders with a loss. A fund without major sponsorship, such as Reserve Primary, might not be able to cover a major error’s cost.
6. Are you comfortable with the fund’s investment policies? Safety is the watchword here, but that means different things to different people. You might want a fund that buys only Treasury bills. In a broader-based fund, you might want certificates of deposit only from the soundest banks and a limited amount of commercial paper.As for derivatives, some of them aren’t particularly dangerous. Others can lose an unexpected amount of value when interest rates suddenly change.
How do you find out what a money fund buys? There’s only one way: read the prospectus. For safety, a suitable disclosure is, “This fund does not invest in derivatives.” Funds that devote many paragraphs to derivatives may be running more risks than even the managers realize.
Funds that consistently pay higher yields than the competition are the ones taking higher risks. And why would you take any risks at all? On $5,000, the dif-ference between 3.5 and 3.1 percent comes to $20 a year. Big deal. If you’ve got $5 million, that 0.4 percent is worth a tidy $20,000—but short of that, why mess around?
A note about tax-exempt money market funds: Some people will do anything to beat Uncle Sam out of a few bucks, even if it costs them money. They buy a tax-exempt fund even if they’d do better in a taxable one. Look at a tax-free fund only if you are in a middle or high federal tax bracket (at this writing, 25 percent and up).
Here’s how to figure whether you’ll net more money from a tax-exempt fund than a taxable one: Subtract your combined state and federal tax bracket from 1.00. Divide the result into the current yield of the tax-exempt fund you’re looking at. The result is your break-even point. If you can find a taxable fund paying more than the break-even point, buy it.
For example, say you’re in the 25 percent bracket and are considering a fund that yields 2.5 percent. Subtracting 0.25 from 1.00 gives you 0.75. Dividing 2.5 by 0.75 gives you 3.33 percent. A taxable fund paying more than 3.33 percent will yield you more, after federal taxes, than the tax-free fund.
Four alerts:
1. A general tax-exempt fund includes the securities of many states. Your state may tax the interest on out-of-state bonds, making these tax exempts less attractive.
2. Single-state funds exist for states with higher taxes (California, Ohio, New Jersey, New York, Maryland, and Pennsylvania, among others). Your divi¬dends should be entirely tax exempt. You take on slightly more risk, however, because you’re not diversified.
3. U.S. government money market funds include a mix of government securities, only some of which are state tax–exempt. Your fund should tell you what’s reportable in your state.
4. Some state and local securities are considered private purpose. That subjects them to the alternative minimum tax, as long as it survives. Ask about this if you’re in an AMT bracket (you know who you are!).
Beware of look-alike money market funds! They yield more than regular funds because they’re invested in the securities of a single company, such as Ford Motor Credit Company or GMAC Financial Services. At this writing, the Ford and GMAC notes are paying the interest due, despite their ties to the shrink¬ing auto industry, but the notes are worth much less than you paid. Money funds need to be diversified to be acceptably safe—or, like bank money market accounts, they need to be federally insured. Check the money fund industry’s current average yield at iMoneyNet (www.imoneynet .com), and be suspicious of any “money account” that pays more.
Beware of “enhanced” cash funds! They’re diversified, but they invest in securities maturing in up to a year instead of super-short-term 30-to 60-day securities. If interest rates rise, the enhanced funds may lose money—not a lot, but enough to notice. Enhanced funds are fine for people who want to take a little risk in the hope of earning a higher return. But they’re not for savers who intended to keep their money safe.
Beware any investment that claims to act like a money fund while paying a sharply higher yield. That was the promise of the complex instruments called auction rate securities. They yielded high returns for 20 years. Then the market froze and investors couldn’t get their money out. Don’t play games with money fund look-alikes. For liquid savings, stick with the real thing.
From MAKING THE MOST OF YOUR MONEY NOW by Jane Bryant Quinn. Copyright © 1991, 1997, 2009 by Berrybrook Publishing, Inc. Reprinted by permission of Simon & Schuster, Inc.