Tags: Money Market

Three Ways to Profit Safely and Avoid the Money Market Fund Meltdown

By , Money Morning •

By Martin Hutchinson
Contributing Editor

Last week, a $5 billion money market fund run by General Electric Co. (GE), the GEAM Cash Trust Enhanced Trust, offered its non-GE investors a new price of 96 cents on the dollar - and encouraged them to cash out.

This should have been bigger news than it was [Although much of the business press underplayed this significant story - or missed it altogether - Money Morning covered it fully, even explaining why it was so worthy of note].

The only previous money market fund to "break the buck" was the Community Bankers U.S. Government Money Market Fund in 1994. But it was only $100 million and wasn't managed by a major investment house.

If top money market funds can no longer be relied upon for complete protection of investor principal, what's safe anymore?

The answer, no surprise, is not very much. Not in these volatile markets. Because of the subprime mortgage crisis, it's no longer enough just to be careful about which stocks you invest in - and even there, extra care is demanded. But now you must scrutinize your money funds, too. This is not good news for individual investors, and we therefore need a strategy to protect our money from any managers who have been stupid.

We're going to provide you with that strategy. But, first, it will help to have a better understanding of just how money market funds function.

Money Market Primer

Money market funds were invented in 1971, as an alternative to bank deposits. In those days, small banks were restricted in the interest rates they could pay regular depositors.

However, interest rates paid on large institutional deposits could float with the prevailing market. Thus, a money market fund manager could place deposits in the wholesale market, deduct a modest fee and still pay a good return to his or her individual investors. In 1974, Merrill Lynch & Co. Inc. (MER) figured out a way to allow investors to write checks against their balances, and an entire new industry was born within the financial services sector.

As interest rates soared and stocks went nowhere during the stagflation-afflicted 1970s, investors came to realize that money markets were the best game in town. Indeed, the money market business soared.

At this stage, with money market funds paying returns of well over 10% per annum, fund managers remained very conservative with their investment choices. All the participants understood that, unlike bank deposits themselves, these funds were not guaranteed by the Federal Deposit Insurance Corp. (FDIC), so fund managers knew that they needed to offer investors as much security of principal as possible.

The share price of the funds should remain $1.00 at all times [Initially, some funds used a share price of $1.000, but that proved vulnerable to small losses, so the price of $1.00 was settled on as the par value of a money fund share]. Managers who wanted to remain in the money market fund business would "top up" any of the infrequent losses to make the fund once again trade at this key $1.00 share price, thus keeping investors whole. This meant that any of the small credit risks taken on investments such as commercial paper would, in practice, be borne by the fund manager - a universal realization that kept everyone very honest.

The Tide Shifts

After 2001-02, things got more difficult. The U.S. Federal Reserve dropped short-term interest rates all the way down to the 1% level, so the returns on money market funds after expenses were little above zero. Since inflation remained nominally in the 1% to 2% range, and in reality was in the 3% to 4% range, investors in money market funds felt ripped off: Their tiny returns kept them well short of matching inflation's erosion of their principal. What's more, they had to pay income taxes on their tiny miniscule income.

Naturally, Wall Street responded to this by employing the time-honored method of offering investors more risk, in this case by putting the money funds into asset-backed commercial paper (ABCP), which offered a higher return. They justified this adventurism by the ratings that rating agencies put on the asset-backed debt, which were ridiculously optimistic - and as we now know, were downright wrong. These riskier funds paid better returns, but still benefited from the investor perception - even belief - that the manager would never allow their price to fall below $1.00.

That dream of decent returns and security of principal is now shattered. GE is one of the biggest names in the market, so if you can't rely on a GE fund, no fund management group can truly be trusted to keep your fund share price at $1.00. Thus, as a fund shareholder, you can no longer sleep at night. To misquote the company's slogan, it's a case of: "GE-we bring bad dreams to life!"

The Way Out of the Money Market Morass

There are three possible ways to solve this problem:

  • First, find a money market fund company you absolutely trust. While I wouldn't recommend Biblical levels of trust for any financial institution, I can say that in my experience, Vanguard comes pretty close. Vanguard has a customer-centric strategy - all its funds are no-load, and it invented the low-cost index fund. And just as important, it has no other significant business beyond managing your money: no investment bank, no turbines... nothing to cause it to lose its focus, and no other revenue streams to fall back on if it louses up its investment-management business. So if it loses its fund reputation, it's dead. That should be comforting. You can either invest in Vanguard's Treasury money market fund, which invests in Treasury bills only (VMPXX), or its regular Prime money market fund (VMMXX). I would avoid Vanguard's Federal money market fund (VMFXX) because a substantial part of its assets will be invested in securities of Fannie Mae and Freddie Mac, both of which are undercapitalized and far too close to the housing problems [and they don't have a real government guarantee, either].
  • A second alternative is to invest in an exchange-traded fund, which itself invests only in Treasury bills: The Spider Lehman T-Bill ETF (BIL) would qualify. That has the disadvantage that you have to pay brokerage fees to buy it and you can't write checks on it, but it otherwise resembles a Treasury money market fund.
  • As a third possibility, if you are worried about the weak dollar, you might consider a foreign currency bond fund such as the no-load T. Rowe Price International Bond Fund (RPIBX), which invests in high quality, non-dollar denominated bonds. Most of that fund's investments are in prime quality non-U.S. borrowers, so you're pretty well insulated from housing junk.

Losing 4% of your money, as GE investors did, is not such a bad fate. But it's very disconcerting if you thought that portion of your portfolio was bulletproof. It's possible to avoid those kinds of problems. And we've just given you a roadmap to get out of the money-market portion of the subprime swamp.

News and Related Story Links: