Money market funds began as a bright and useful idea,
became a habit, and recently have become a bad habit.
Money market funds were invented in 1971 as an innovative
end-run around Federal Reserve Regulation Q, which prohibited paying interest
on demand deposits. The purpose of Reg Q was to
stifle competition in the deposit-taking business in order to benefit
commercial banks – at the expense, of course, of depositors.
The regulation had little effect until the late 1960s,
when two factors converged. The first was consumer price inflation; it was
mild compared to what was soon to follow, but it was still noticeable, and it
fueled a general rise in interest rates. The second factor was the arrival of
the IBM 360, which made computing much cheaper. Before that device, the
administration of checking accounts was still labor intensive and little
advanced from the days of green eye-shades. It was expensive for banks to
maintain checking accounts, so they weren't inclined to pay interest on them,
Reg Q or no Reg Q.
Then the drop in the cost of maintaining checking
accounts and a rise in the revenue that could be earned from investing
depositors' money turned demand deposits into a very attractive proposition
for banks. Since Reg Q forbade head-on competition
for deposits, individual banks did what cartel members always do when there
are profits to be made – look for ways to compete indirectly. In lieu
of paying interest, banks began giving away premiums to attract large
deposits. The era of the free bank toaster was born.
The first money market fund, Reserve Fund, went far
beyond small appliances to exploit the opportunity provided by high interest
rates and cheap data processing. The legal strategy devised by the fund's
promoters was to avoid the regulatory environment of banking with its Reg handcuffs and instead to set up shop as a
SEC-registered mutual fund. But unlike any mutual fund up until then, it
didn't invest in stocks and bonds; it invested in jumbo bank CDs earning
open-market yields. And its share price didn't fluctuate; it was held steady
at $1.00 by paying a tiny dividend every day, which could be reinvested
automatically in more shares. Shareholders could redeem by writing a check,
which the fund would cover when it was presented to the bank where the fund
kept its checking account.
From an investor's point of view, Reserve Fund was
functionally a bank, even though legally it was an investment company. But
for all intents and purposes, it was a bank with zero net capital, which
meant that its investment policy had to be emphatically conservative. So,
since the jumbo CDs that the Reserve Fund was buying were far bigger than
FDIC insurance limits, the fund bought only from banks it considered
indestructible. Shortly after Reserve Fund opened for business, another
invention, Capital Preservation Fund, took conservatism to an extreme with a
policy of investing only in Treasury bills. This made the fund's shares
arguably as safe or safer than FDIC-insured
deposits, and with no limitation on size (the FDIC insurance limit at the
time was $10,000).
Good as the idea was, money market funds got off to a
slow start with the public, but the continued upward trend in inflation and
in interest rates soon turned them into a giant industry with hundreds of
funds and a river of management fees flowing to their promoters. And for the
most safety-minded investors, the Treasuries-only funds offered a welcome
refuge from worries about the reliability of commercial banks.
Money market funds are still a giant industry, but you
have to ask why. Limits on bank deposit interest rates are long gone for
individuals, so even before today's near-zero
returns, the yield advantage on money market funds was modest at best. And
with the bogeyman of sovereign default peeking out of so many windows lately,
the phrase "Treasury bills-only" no longer has quite the
tranquilizing effect it once did. In fact, given that most FDIC-insured deposits
are owned by Americans (aka potential voters) while much of the Treasury debt
is owned by non-voting foreigners, FDIC-insured bank
deposits may be a better bet than T-bills.
Take a look at what is now the largest retail money
market fund – Fidelity Cash Reserves. It has $120 billion in assets.
The yield for investors is 0.01% – keep a hundred dollars in the fund
for a year and you get a penny. Put $10,000 into the fund and twelve months
later you have $10,001. And there are risks: the fund holds nearly 52% of its
assets in uninsured bank CDs and another 14% in commercial paper. I can only
surmise that most of the $120 billion is there because of investor habit and
inertia.
Money Market Funds: An Idea Whose Time Has Passed
Today there is little good reason to use a money market
fund for substantial amounts of cash.
1. There is no material yield advantage because there
is no material yield on cash anywhere – unless you are willing to take
risks that mock the idea of cash. The highest yield on a money market fund I've seen since the Federal
Reserve hammered rates into the floor at the end of 2008 was an offshore
operation called Bank of Ireland USD Liquidity Fund, with a yield of 0.54%.
How the fund earned that much (after expenses) in a world where 30-day jumbo CDs
return 0.20% and one-month T-bills yield 0.04%, I don't know. But if the
fund's risk disclosure was adequate, it would have included language that
amounted to "Baby needs shoes!"
2. With most money market funds, there is a material
safety disadvantage vs. FDIC-insured CDs since, of course, commercial
paper and jumbo CDs carry a risk of default.
3. With a T-bill-only fund, the best you can say in
favor of the fund vs. FDIC-insured CDs is that it's a tossup. Both are very
secure.
If you invest with a family of mutual funds, moving
redemption proceeds into a money market fund in the same family is
convenient. But I recommend enjoying that convenience only if the fund really
is limited to Treasury bills. And you'll have to read the fund's prospectus
to be confident that that is the case. Don't rely on the fund's name to tell
you where your money is. A "government-only" fund typically invests
in IOUs from US government agencies or government-sponsored enterprises or in
private loans secured by such IOUs. Even if the fund has "Treasury"
in its name, you may find upon close examination that T-bills are the primary
investment but that the fund puts 15% or 20% of its assets into uninsured CDs
to spice things up. So if you consider the homework needed to be sure you're
getting T-bills and nothing but T-bills, the convenience argument for using
the fund gets weak.
The reason for holding part of your wealth in cash is
absolute protection from default risk. If a money market fund doesn't provide
that protection, it isn't really a cash medium. It's
something else.
[Even though they may not know it, few mainstream
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