Cashing In On Money Funds

Mind you, money market funds shouldn't be confused with the money market deposit accounts offered by banks. Those were set up to compete with money market funds but don't offer yields that are as high. Although money market deposit accounts may provide more safety because the Federal Deposit Insurance Corp. (FDIC) insures them up to $100,000 per account, as you will see, money market funds may be the better choice.

WHAT ARE THEY?

According to MSN MoneyCentral.com, money funds, or money market funds, are mutual funds that invest in short-term, high-quality debt instruments such as Treasury bills, commercial paper, banker's acceptances, certificates of deposit, repurchase agreements, money market preferred stock, and Eurodollar certificates. The net asset value (NAV) of a money fund is always $1 per share, so 100 shares of a money fund will cost $100. The only fluctuating variable is the interest, or yield. This is passed on to the investor in the form of dividends, minus, of course, all management expenses. As with any other mutual fund, you can set up your fund to automatically reinvest the dividends.

Money market funds can be separated into two categories, taxable and tax-free. Taxable funds are subject to federal and state income taxes. Tax-free money funds invest only in municipal securities, so the interest earned is not subject to federal taxes. If you are in a high tax bracket, you may be able to reduce your taxes by investing in a money fund that is free from state and local taxes as well. Because the interest is tax-free, you can expect a lower yield with these funds than the taxable money funds. For large accounts, however, the tax savings are likely to outweigh the yield issue.

The FDIC does not insure money market funds, but they are closely regulated by the US Securities and Exchange Commission (SEC) and are virtually guaranteed not to lose money. There have been instances when money funds have lost money, but the fund company has always backed the losses to prevent investors from losing money invested in their money market funds.

THE ADVANTAGES

Most money funds give you the option of withdrawing money from the account via check-writing privileges. Usually, however, there are limits on the minimum check amount and the number of checks you can write. Still, this is a nice feature that other cash instruments, such as certificates of deposit, do not offer.

The yield on a money market fund is usually around 4-6% annually, much higher than the typical savings account. This makes money funds an excellent place to store money on a temporary basis or for a short-term application that requires minimum risk, such as a down payment for a car or house, next year's tuition, or your emergency stash.

Money funds can also be used to store money during periods of high market volatility. During an economic recession or a stock market correction, the 4-6% annual return of a money fund will outperform many stock funds. As a long-term investment, that 4-6% yield might not outpace inflation, but when compared to a traditional savings account, a money fund will come out looking rosy.

Most money market funds have lower expense ratios than do stock or bond funds. You should have no difficulty finding one with an expense ratio of less than 1%.

If you can't decide where to invest, it may help (especially in a bear market) to park your money in a money market fund until you decide what to do with it. After all, most likely switching funds within the same company isn't going to cost you anything.

WHAT TO LOOK FOR

The strategies you need to apply when you consider investing in a money market fund are similar to those for stock or bond mutual funds. Obtain a prospectus for each fund and review the investment goals and objectives. Look at the long-term average yields -- expenses as well as initial minimum investment. When looking at expenses, make sure they have been low year after year. Some funds will waive their management fees to make their yield appear higher than it actually is. Then, after attracting investors, the fund will stop waiving the fees.

If you have access to the Internet, you may want to check out www.imoneynet.com or www.bankrate.com for money market mutual fund and money market account information. There, you will find the average money market fund rates as well as rates on money market deposit accounts and CDs.

You can see some details of three popular taxable money market funds in Figure 1. All three have fairly low minimum investments, above-average returns, and check-writing services. The Vanguard Prime Money Market Fund and Fidelity Cash Reserves Fund are two of the largest money funds available.

CONCLUSION

Money funds are ideal short-term investments where minimum risk is preferable. Because their yields are higher than those offered by traditional savings accounts, they might be a better option. Check-writing services and the lack of redemption fees make money funds liquid instruments, so they are ideal for emergency reserves or any cash necessary for the short term, especially within a year. Some investors may also like using money funds for temporary storage when the stock market takes a tumble. If you are looking for safety in your investing and you're tired of the 2-3% return on your savings account, you might want to look into money market mutual funds.

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ADVANTAGES AND DISADVANTAGES OF MONEY MARKET FUNDS

Advantages

• Cash equivalent investment
• Check-writing privileges
• On average, lower fees than stock or bond funds
• In many cases, low investment minimum
• Tax-free options
• Transactions by telephone, mail, or wire
• Typically, higher yields than bank money market accounts

Disadvantages

• Limits on check size and number of checks allowed
• Money not insured
• Not for long-term investing -- may not outpace inflation
• For taxable funds, must pay local, state, and federal taxes on interest earned

--S.M.

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Sean Moore can be reached at SMoore@Traders.com.