Chapter 7
Managing Money Market Funds
IN THIS CHAPTER
Understanding the risks and rewards of money funds
Selecting the right fund for your situation
Finding the best alternatives to money funds
For many years, folks kept their spare cash in a local bank, and for good reason. The local bank was convenient, offered safety and peace of mind with the government backing for money on deposit, and generally paid some interest on the money.
In the 1970s, however, the investment landscape changed for smaller investors. Interest rates and inflation increased, yet banks were limited by regulations in the interest rates they could pay depositors. Thus was born the money market fund.
In this chapter, I discuss the risks and rewards of money funds, uses for funds, and how to pick the best ones to help you meet your investing goals.
Defining Money Market Mutual Funds
Money market mutual funds began in 1971. They invested in the higher-yielding financial instruments that were accessible only to larger institutional investors with large sums to invest. Money market funds “democratized” these investments by selling shares to investors with relatively small amounts to invest. By pooling the money of thousands of investors, and after charging a reasonable fee to cover their operational expenses and make a profit, money market funds were able to offer investors a better yield than typical bank accounts.
Money market funds are unique among mutual fund company offerings because they don’t fluctuate in value and maintain a fixed $1-per-share price. (An exception: During the 2008 financial crisis, the Reserve Primary fund had a small portion of its investments go bad, and some shareholders lost just under 1 percent of their invested principal.) As with a bank savings account, your principal investment in a money market fund doesn’t change in value.
With a money market fund, your investment earns dividends. Dividends are much like the interest you receive from a bank savings account.
Making sense of the appeal of money market funds
The best money market mutual funds offer the following benefits over bank savings accounts:
- Higher yields: Money market mutual funds generally yield more because they don’t have the higher costs that banks do from having branch offices all over. Banks can get away with paying lower yields because they know that many depositors believe that the Federal Deposit Insurance Corporation (FDIC) insurance that comes with a bank savings account makes it safer than a money market mutual fund. (For more on the safety of money funds compared with banks, see the next section, “Understanding the drawback of money market funds”). Also, the FDIC insurance is an expense that banks ultimately pass on to their customers. (See Chapter 6 for more on banks and banking options.)
- Tax-free flavors: If you’re in a high tax bracket, tax-free money market funds offer you something that bank accounts don’t. Bank accounts only pay interest that is fully taxable at both the federal and state levels. Money market funds can be state and federal tax-free (for folks in high tax brackets), just federal tax-free (for folks in a high federal tax bracket), or fully taxable.
- Check writing: Another useful feature of money market mutual funds is the ability they provide you to write checks, free of charge, against your account. Most mutual fund companies require that the checks that you write be for larger amounts — typically $250 minimum. Some brokerage cash management accounts that include money funds (at firms like Charles Schwab, Fidelity, T.D. Ameritrade, and Vanguard) allow you to write checks for any amount. With these types of money market fund accounts, you can ditch your bank completely because such accounts often come with debit cards that you can use at bank ATMs for a nominal fee. (Some brokerage firms levy service fees if you don’t have enough assets with them or don’t have regular monthly electronic transfers, such as direct deposit of your paycheck.)
Understanding the drawback of money market funds
The best money market mutual funds have higher yields, tax-free alternatives, and check writing — features not offered by bank savings accounts. But you need to know about one difference between bank accounts and money market mutual funds: Money funds aren’t insured (except for a one-year period during the 2008–2009 financial crisis).
Bank accounts come with FDIC insurance that protects your deposited money up to $250,000 (see Chapter 6). So if a bank fails because it lends too much money to people and companies that go bankrupt or abscond with the funds, you should get your money back from the FDIC.
The lack of FDIC insurance on a money fund shouldn’t trouble you, however. Mutual fund companies can’t fail because they have a dollar invested in securities for every dollar that you deposit in their money funds. By contrast, banks are required to have available just a portion — about 10 cents for every dollar that you hand over to them.
Cases have occurred in which money market funds bought some investments that declined in value. However, in all but one case involving funds taking in money from retail investors like you and me, the money funds kept their $1-per-share price.
If you’re concerned about the lack of FDIC insurance on a money market fund, stick with money market funds from the bigger mutual fund companies. They have the financial wherewithal and the biggest incentive to save a foundering money fund. Fortunately, the bigger fund companies typically have the best money funds anyway.
Understanding Money Market Fund Holdings
Money market funds are a safe, higher-yielding alternative to bank accounts. Under Securities and Exchange Commission regulations, money market funds can invest only in the highest-credit-rated securities, and their investments must have an average maturity of less than 60 days. The short-term nature of these securities effectively eliminates the risk of money market funds being sensitive to changes in interest rates (a concern with bonds, which are covered in Chapter 9).
The securities that money market funds buy and hold are extremely safe. General-purpose money market funds invest in government-backed securities, bank certificates of deposit, and short-term corporate debt that the largest and most creditworthy companies and the U.S. government issue.
You may not know (or care) what these holdings are. However, here’s a short explanation of the most common money fund holdings to aid your understanding and comfort level:
- Commercial paper: Larger corporations often need to borrow money to help make their businesses grow and prosper. In the past, most companies needing a short-term loan had to borrow money from a bank. In recent decades, issuing short-term debt known as commercial paper directly to interested investors has become easier. Money market funds buy high-quality commercial paper issued by large companies, banks, and foreign governments.
- Certificates of deposit: When you put your money in a certificate of deposit (CD) at your local bank, what you’re doing is making a specific-term loan (3 months, 6 months, 2 years) to your bank. Money market funds can buy CDs as well. When they do, however, they usually invest millions of dollars in bank CDs. Thus, they can command a higher interest rate than you can get on your own. Money funds buy CDs that mature within a couple of months. The money fund is insured only up to $250,000 per bank CD (so they may use multiple banks), just like the bank insurance that customers receive. As with other money fund investments, the money fund does research to determine the credit quality of banks and other institutions that it invests in. Remember that money funds’ other investments aren’t insured.
- Government debt: The U.S. federal government has trillions of dollars in debt outstanding in the form of Treasury securities. In addition to investing in Treasuries soon to mature, money funds invest in short-term debt issued by government-affiliated agencies. Some money market funds specialize in certain types of government securities that distribute tax-free income to their investors. Treasury money market funds, for example, buy Treasuries and pay dividends that are state-tax-free but federally taxable. State-specific municipal money market funds invest in debt issued by state and local governments in one state. The dividends on state money funds are federal-tax-free and state-tax-free, if you’re a resident of that state.
Protecting and Accessing Your Money in Money Funds
A potentially big psychological impediment to some folks using money funds is that they must deal with money funds online, by phone, and through the mail. That creates some worries, like one of your checks getting lost or stolen and how accessible your money is, but protecting and accessing your money isn’t as challenging as it may seem.
Protecting your money
Checks received and sent from a money market fund are just as safe as those received and sent from any other type of account. No one can legally cash a check made payable to you. Don’t mistakenly think that going to your local bank in person is safer. Bank robberies happen all the time, totaling in the thousands annually.
Increasing numbers of money market funds offer mobile apps that enable you to take a picture of and deposit checks with your smartphone, all from the comfort of your home or wherever you happen to be. If your fund company doesn’t offer a mobile check deposit app and you’re really concerned about sending a check in the mail, use a fund company or discount broker with branch offices reasonably close to your home or office. I don’t recommend spending the extra money and time required to send your check by way of registered or certified mail. You know if your check got there when you get the transaction entry from the fund company processing the deposit.
In those rare cases where a check does get lost, remember that checks can be reissued. And when you’re depositing a check made payable to you, be sure to endorse the check with the notation “For deposit only” along with your account number under your signature.
Accessing your money
With most money market mutual funds, you will likely be sending your money to a company out of state, so it may seem to you that you won’t be able to access these funds efficiently if you need to. However, you can efficiently tap your money market fund in a variety of ways. You can use the following methods at most fund companies:
- Check writing: The simplest way to access your money market fund is to write a check. Suppose you have an unexpectedly large expense that you can’t afford to pay out of your bank checking account. Just write a check on your money market mutual fund.
- Electronic transfers: Another handy way to access your money is to call the fund company and ask to have money sent electronically from your money market fund to your bank account, or vice versa. Such transactions can also usually be done on fund companies’ websites and typically take one business day to complete. Or you can have the fund company mail you a check for your desired amount from your money fund (although that obviously isn’t a “quick” way to get needed money). If you need money regularly sent from your money market fund to, say, your local bank checking account, you can set up an automatic withdrawal plan. On a designated day of the month, your money market fund electronically sends money to your checking account.
- Debit cards: Brokerage account money funds that offer debit cards allow access to your money through bank ATMs. Just find out first what fees you may have to pay for using particular ATM networks.
- Wiring: If you need cash in a flash (for example, same day), many money market funds offer the option of wiring money to and from your bank. Both the money market fund and the bank usually assess a small charge for this service. Most companies can also send you money via an overnight express carrier, although you’ll likely have to foot that bill.
Unlike when you visit a bank, you can’t simply drop by the branch office of a mutual fund company (even if it happens to be nearby) and withdraw funds from your account. Money market fund companies don’t keep money in branch offices because they’re not banks. However, you can establish the preceding account features, if you didn’t set them up when you originally set up your account, by mailing in a form or by visiting the fund’s branch office. Alternatively, you may be able to add these services to your account through the fund company’s website.
Using Money Market Funds in Your Investment Plan
The best money market funds enable you to substitute for a bank savings account while offering comparable safety to a bank, but with a better yield. Money market funds are well suited for some of the following purposes:
- Rainy-day/emergency reserve: Because you don’t know what the future holds, you’re wise to prepare for the unexpected, such as job loss, the desire to take some extra time when changing jobs, unexpected health care bills, or a leaky roof on your home. Three to six months’ worth of living expenses is a good emergency reserve target for most people. (If you spend $2,500 in an average month, for example, keep $7,500 to $15,000 in reserve.) Three months’ living expenses may do if you have other accounts, such as a 401(k), or family that you could tap for a loan. Keep up to one year’s expenses if your income fluctuates greatly. If your profession involves a high risk of job loss, and if finding another job could take a long time, you also need a significant cash safety net.
- Short-term savings goals: If you’re saving money for a big-ticket item that you hope to purchase within the next couple of years — whether it’s an HDTV, a car, or a down payment on a home — a money market fund is a sensible place to save the money. With a short time horizon, you can’t afford to expose your money to the gyrations of stocks or longer-term bonds. A money market fund offers a safe haven for your principal and some positive return.
- A parking spot for money awaiting investment: Suppose you have a chunk of money that you want to invest for longer-term purposes, but you don’t want to invest it all at once, for fear that you may buy into stocks and bonds just before a big drop. A money market fund can be a friendly home to the money awaiting investment as you gradually move it into your chosen investment. (I explain this technique, known as dollar cost averaging, in Chapter 5.)
- Personal checking accounts: You can use money market funds with no restrictions on check writing for household checking purposes. Some discount brokerage services that offer accounts with a check-writing option downplay the fact that an investor is allowed to write an unlimited number of checks in any amounts on his or her account. You can leave your bank altogether; some money funds even come with debit cards that you can use at bank ATMs for a nominal fee.
- Business accounts: You can also open a money market fund for your business. You can use this account for depositing checks received from customers and holding excess funds, as well as for paying bills by means of the check-writing feature. Some money funds allow checks to be written for any amount, and such accounts can completely replace a bank checking account.
Shopping for the Best Money Funds
If you’re interested in putting some of your money into a money market mutual fund, in this section, I name names. Before getting to that, however, allow me to explain what I look for when selecting a money market fund.
Understanding traits of leading money funds
When looking for an outstanding money market fund, look for these attributes:
- Low expenses: Select a money market fund that does a good job of controlling its expenses. The operating expenses that the fund deducts before payment of dividends are the biggest determinant of yield. All other things being equal (which they usually are with different money market funds), lower operating expenses translate into higher yields for you. Within a given category of money market funds (general, Treasury, municipal, and so on), fund managers invest in the same basic securities. The market for these securities is pretty darn efficient, so “superstar” money market fund managers may eke out an extra 0.1 percent per year in yield, but not much more. Lower expenses don’t mean that a fund company cuts corners or provides poor service. By attracting more money to manage, efficiently managed larger funds are able to manage money for a lower expense percentage.
- Tax appropriate for your situation: With money market funds, all your return comes from dividends. What you actually get to keep of these returns is what’s left over after the federal and state governments take their cut of your investment income. If you invest money that’s held outside a retirement account, and you’re in a high tax bracket, you may come out ahead if you invest in tax-free money market funds. (Tax-free refers to the taxability of the dividends that the fund pays. You don’t get a tax deduction for money that you put into the fund, as you do with certain retirement accounts.) If you’re in a high-tax state, a state money market fund — if a good one exists for your state — may be a sound move.
- Other attractive fund offerings: Consider what other investing you plan to do at the fund company where you establish a money market fund. Suppose you decide to make mutual fund investments in stocks and bonds at a specific fund company. In that case, keeping a money market fund at a different firm that offers a slightly higher yield may not be worth the time and administrative hassle, especially if you don’t plan on holding much cash in your money market fund.
- Associated services: Good money market funds offer other useful services included with their accounts, such as check writing, telephone exchange and redemptions, and automated electronic exchange services with your bank account.
Most mutual fund companies don’t have many local branch offices. Generally, this fact helps fund companies keep their expenses low so they can pay you greater money market fund yields.
You may open and maintain your mutual fund account via the fund’s company’s website, toll-free phone lines, or the company’s website. You don’t really get much benefit from selecting a fund company with an office in your area (although you may feel some peace of mind).
Naming good money funds
Using the criteria in the preceding section, in this section, I recommend good money market funds — that is, those that offer competitive yields, check writing, access to other excellent mutual funds, and other commonly needed money market services.
Money market funds that pay taxable dividends may be appropriate for retirement account funds that await investment as well as non-retirement-account money when you’re not in a high federal tax bracket and aren’t in a high state tax bracket (less than 5 percent).
Here are the best taxable money market funds to consider:
- Fidelity Cash Reserves
- T. Rowe Price Summit Cash Reserves (higher yields if you invest $25,000)
- Vanguard’s Prime Money Market
Consider U.S. Treasury money market funds if you prefer a money market fund that invests in U.S. Treasuries, which maintain the safety of government backing, or if you’re not in a high federal tax bracket but are in a high state tax bracket (5 percent or higher).
Here are the U.S. Treasury funds that I recommend:
- Fidelity’s Government Money Market
- USAA’s Treasury Money Market
- Vanguard Treasury Money Market
Municipal (also known as muni) money market funds invest in short-term debt that state and local governments issue. A municipal money market fund, which pays you federally tax-free dividends, invests in munis issued by state and local governments throughout the country.
A state-specific municipal fund invests in state and local government-issued munis for one state, such as New York. So if you live in New York and buy a New York municipal fund, the dividends on that fund are federal and New York state tax-free.
So how do you decide whether to buy a nationwide or state-specific municipal money market fund? Federal tax-free-only money market funds may be appropriate when you’re in a high federal tax bracket but not in a high state bracket (less than 5 percent). State tax-free municipal money market funds are worth considering when you’re in a high federal and a high state tax bracket (5 percent or higher).
If you’re in a higher state tax bracket, your state may not have good (or any) state tax-free municipal money market funds available. If you live in any of those states, you’re likely best off with one of the following national municipal money market funds:
- T. Rowe Price Summit Municipal Money Market ($25,000 minimum)
- USAA Tax-Exempt Money Market
- Vanguard Tax-Exempt Money Market
Fidelity, USAA, and Vanguard have good funds for several states. If you can’t find a good state-specific fund for your state, or you’re in a high federal tax bracket only, use one of these nationwide muni money markets.
Alternatives to Money Market Mutual Funds
Banks developed an account that is similar to a money market mutual fund, which they typically call a money market deposit account (MMDA). Banks set the interest rate on MMDAs, and historically, those rates have been a bit lower than what you can get from one of the better money market mutual funds (although this has been less true during the extended period of low interest rates during the 2010s). Check writing on MMDAs, if it’s available, may be restricted to a few checks monthly.
As latecomers to the mutual fund business, some banks now offer real money market mutual funds, including tax-free money funds. Again, the better money market mutual funds from mutual fund companies are generally superior to those offered by banks. The reason: Most bank money market funds have higher operating expenses and, hence, lower yields than the best money funds offered by mutual fund companies.
Although I advocate use of the best money market funds, I realize that a bank or credit union savings account is sometimes the most practical place to keep your money. Your local bank, for example, may appeal to you if you like being able to conduct business face to face. Perhaps you operate a business where some cash is processed; in this case, you probably can’t beat the convenience and other services that a local bank offers.
If you have only $1,000 or $2,000 to invest, a bank savings account may be your better option; the best money market funds generally require a higher minimum initial investment.
For investing short-term excess cash, you may first want to consider keeping it in your checking account. This option may make financial sense if the extra money helps you avoid monthly service charges because your balance occasionally dips below the minimum. In fact, keeping money in a separate savings account rather than in your checking account may not benefit you if service charges wipe out your interest earnings. This is especially true with interest rates at such relatively low levels.
Be sure to shop around for the best deals on your checking account because minimum balance requirements, service fees, and interest rates vary. Credit unions offer some of the best deals, although they usually don’t offer extensive access to free ATMs (see Chapter 6). The largest banks with the most ATMs generally don’t have the best terms on checking and savings accounts.