The Error-Proof Portfolio: What You Don't Know About Your Cash Could Hurt You

Last Wednesday, SEC head Mary Schapiro scuttled a controversial plan that would have reformed the way money market funds work. Under the reforms, the net asset values of money market funds would "float" to reflect the true value of their underlying securities. Money market providers would also have to place limits on redemptions and set aside capital to help make up for sudden losses in their holdings.

The goal of these changes was to help prevent a recurrence of the run-on-the-bank scenario that plagued a large money market fund, Reserve Primary fund, in the fall of 2008. When that fund broke the buck--that is, the value of its holdings dropped, taking the fund's net asset value below $1--investors pulled money out in droves. To help prevent further runs, the Federal Reserve and Treasury Department installed a temporary backstop for money market fundholders, guaranteeing a $1 NAV, subject to certain limits; that program has since ended.

Reports Friday morning indicated that government agencies, including the Treasury and Fed, were considering additional ideas to stave off the need for similar government intervention down the road. But until any new rules are settled upon, it's important that many money market fund investors understand exactly what they're getting--and not getting--with these holdings.

Here are some key items to keep in mind as you manage your cash holdings.

Stable NAV Is a Convention, Not a Guarantee
Perhaps the most important fact to be aware of with money market fund holdings is that there are no guarantees that what you put in is what you will get out. Although money market funds are required to stick with highly liquid, high-quality, short-term securities, and those requirements were tightened further in the wake of the financial crisis, the value of those securities has the potential to fluctuate if there are concerns about an issuer's financial wherewithal. When that happens, as was the case with the Reserve Primary fund's holdings in short-term paper issued by financials firms, including the now-defunct Lehman Brothers, the NAV of the portfolio has the potential to drop below the $1 mark.

In reality, breaking the buck has been exceedingly rare over the years--in the 25 years preceding the Reserve Primary incident, just one small fund had broken the buck. What investors might not know, however, is that their money market funds' holdings might have dropped in value but they weren't aware of it because the money market provider stepped in to ensure that investors were made whole, that is, adding its own money to bring the NAV back up to $1. Indeed, in a Congressional testimony, SEC chairwoman Schapiro noted 300 instances of money market fund providers quietly stepping in to prop up their funds' NAVs, even though the value of their holdings had dropped. (Observers within the fund industry said the reports overstated these occurrences because many of them occurred in the distant past.) Many assume, quite reasonably, that the reputational risk of breaking the buck would prompt big financial providers to make investors whole, and that's largely been the case. However, it's worth noting that they're not obligated to do so. For this reason, Morningstar managing director Don Phillips has called money market funds "a well-executed fiction."

No Explicit Backstops
It's also important to understand that, with the exception of the temporary guarantees for money market fundholders put in place during the financial crisis, money market fund assets aren't guaranteed by the FDIC. That stands in contrast with money held in checking and savings accounts, certificates of deposit, and money market deposit accounts, which do carry FDIC protections, up to the limits outlined here. In a related vein, it's important to know that despite their similar names, there's a distinction between money market deposit accounts and money market mutual funds. The former are covered by FDIC guarantees; the latter are not. Thus, in a worst-case scenario in which the value of a money market fund's securities dropped below the $1 NAV and the fund firm didn't make investors whole, there is no explicit government protection.

How to Protect Yourself
Given the aforementioned risks, as well as the fact that money market fund yields aren't appreciably higher--and in some cases are lower--than other cash accounts these days, it's probably not surprising that investors have been yanking money from these funds during the past few years. At the same time, money market funds have some advantages over competing cash instruments. From a logistical standpoint, holding cash assets alongside longer-term assets is much more convenient than having to transfer money between institutions. And up until recently, money market fund investors had typically earned higher yields than bank-account investors; that gap could well open up again in a more normal yield environment.

Thus, if you decide to stick with your money market fund holdings, there are some common-sense steps you can take to ensure that your fund doesn't run into trouble. The first is a good rule of thumb for any income-producing investment: Focus like a laser on costs because lower-cost funds are able to deliver competitive yields without having to delve into risky securities to do so. The Reserve Primary fund didn't have a particularly low expense ratio at the time it ran aground but it did have one of the money market fund universe's highest yields--in hindsight a red flag that management was taking on outsized risks. Many fund shops are currently waiving a portion of their money funds' expenses to keep investors in the black; check with your fund company or read its prospectus to see how high expenses could go if those waivers are removed. Look for expense ratios of 0.35% or less.

Also be aware of the different types of money market funds. Those with "government" or "federal" in their names must invest the lion's share of assets in government-issued paper and therefore are the safest types of money market vehicles. Municipal money market funds invest in paper issued by municipalities, the income from which is free of most federal tax and in some cases state taxes, as well. "Prime" money market funds, meanwhile, have more leeway to invest in corporate paper and often have higher yields. These days, yields are so low across the board that the differences among these fund types aren't significant, but the gaps could widen when yields pick up.

Last but not least, savvy money fund investors need to ask themselves how likely the sponsoring fund firm would be to step in and make investors whole if one of its money funds ran aground. That's a complicated question, of course, but breadth of a firm's operations should provide at least some reassurance. Not only are larger firms more likely to have other profitable endeavors they could rely on to offset trouble in their money funds, but they'd also be more concerned that trouble in their money funds could damage the reputation of their other financial operations.

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