Money Market Funds Advantages and Disadvantages

money market funds advantages and disadvantages

In recent years, money market fund investments have become increasingly popular as investors have become increasingly risk-averse. Particularly, during the recent credit crisis, investors have discovered a sort of safer investments in money market funds as opposed to short-term bonds and traditional savings accounts. However, the drop of the share price of Reserve Primary Fund (RFIXX) below the $1 level (‘breaking the buck’) has shown that money market funds are not the safest of options for risk-averse investors.

Money market funds use the invested money to buy into a large pool of short-term bonds that may include corporate bonds, government bonds or municipal bonds. Unlike other investment vehicles such as stock and bond mutual funds that are subject to price fluctuations, money market funds maintain a net asset value (NAV) of $1.00 per share. This gives investors the feeling that money market mutual funds have virtually no risk.

Money market mutual funds were not supposed to lose their value. Their short-term nature (290 days) provides a considerable level of security against default because, typically, corporate difficulties do not arise in such a short period of time. Theoretically, if a company faces difficulties that would make lending to it a risky option, it would take more than 290 days for the money market mutual funds to exchange their securities at full value. Yet, the default of Lehman Brothers in 2008, the Internet bubble and the implosion of Enron are prominent examples of major companies that defaulted on their debt seemingly overnight.

Money market funds are risky because they are subject to different factors that can drive their price below $1 level. Breaking the buck implies that investors’ returns are less than the invested principal. Indeed, the price decline of the Reserve Primary Fund to 97 cents a share has shown that money market funds can lose their value and be as illiquid as any other mutual fund.

For 2010, analysts cannot estimate accurately when and if there will another surprise related to money market investments. However, there are some factors that are likely to contribute to money market funds ‘breaking the buck’ barrier, affecting their value.

In particular:

a) Company’s declining assets

Since mid-2009, capital markets have been on an uptrend bull rally as many companies reported profits. On the other hand though, the banking sector continued to fail and job losses continued to mount across several industries. For 2010, the uncertainty is likely to limit investment, while new regulation for investor protection are likely to be implement throughout the year. In such an uncertain and turbulent environment, companies may not be profitable enough to sustain a net asset value of $1.00 in their bonds. If the company whose bonds the money market funds owns faces financial problems, the bonds’ value will decline causing a proportional decline in value in the funds owned by each shareholder.

b) Investors redeeming simultaneously

In majority, money market funds are invested in short-term bonds that have similar maturity dates. If a large number of investors redeem their money simultaneously, it will create a major problem of liquidity in the market that will cause loss in the value of money market funds. Large simultaneous redemptions could lead a money market fund to sell a part of its assets prior to their maturity date. This may cause a decline in the value of fund.

The truth of the matter is that ‘breaking the buck’ happens all the time. Investors may not realize it because it is not obvious, but considering that they spend their after-tax, after-inflation money, it is certain that by factoring in tax and inflation, money market funds lose their value. However, as this is more a technical thing, investors seek for the confidence level associated with the fact that the NAV will almost never fall below the $1 level.

Money market mutual funds diversify their short-term investments to protect investors against unexpected difficulties. In doing so, even if one company were to unpredictably default on its debt, the other investments would trade-off for those losses. Besides, in case of a widespread fluctuation in the short-term debt markets, the price of all short-term securities could drop considerably regardless of the financial situation of the individual companies that issued the debt. This explains the “breaking the buck” situation of 2008 where several money market mutual funds collapsed.

Investor expectations in relation to net asset value, particularly after years of consistent NAV, are that a major crisis is required to cause a severe fluctuation in the net asset value of money market funds. However, as investor confidence is shaken, it is possible that, in 2010, money market funds are not an option, unless investors feel protected under new regulations that will allow borrowing and investing with evident reassurance. The Treasury temporarily guaranteed money market mutual funds aiming to put off further investor confidence problems in the short-term debt markets. To that end, the Federal Reserve guarantee that was originally scheduled to expire in October, 2009 has been extended until February 1, 2010.

Tips For Choosing The Right Mutual Fund

For most people, when it comes to investing there aren’t a lot of fancy options out side the stock market. Some dabble in real-estate, but beyond that there’s not much for the casual consumer to invest in that’s worthwhile. Fortunately there are plenty of good stocks and mutual funds to choose from, but navigating through the thousands of choices can be a bit confusing. Take a moment and consider these caveats before looking at mutual funds.

Managing Time and Risk. Your investment should match the time period you plan on leaving it invested. Money that will be needed in the short term should be in funds that take much less risk and have low volatility, such as a money market fund. Investments which do not need to be taken out for decades can be placed in more aggressive funds which will do very well over a long period of time, but have great amounts of volatility.

Watch Out For Fund Expenses. Over a long period of time, high mutual fund expense ratios can degrade a mutual fund’s performance by quite a large measure. Expense ratios are the percentage of your mutual fund you will pay each year to the mutual fund manager to invest the money for it. Generally, the lower expense ratio, the better, assuming all else is equal. Actively managed funds usually have higher expense ratios, because a mutual fund manager is actively picking out new stocks for the fund to invest in.

Be Wary of “Best Fund” Lists. Each year many financial magazines and publications will come out with their list of best mutual funds. The reality is that mutual funds will vary from year to year, and that the “best” one for the year, might do quite poorly the next year. If the top performer was a sector-specific fund for an industry was doing really well one year, and a bad piece of news happens for the industry, your mutual fund could definitely take a turn for the worse.

Watch out for Taxable Distributions. Mutual funds will quite often make a taxable distribution near the end of the year. If you plan on investing in a fund that provides one of these, find out when the fund plans to distribute dividends. Investing just before a taxable distribution will return part of your investment to you, but it will be taxable income and will not increase the value of the account.

Track Record is King. The single most important thing to look at when choosing a mutual fund is its historical rate of return. Compare how well the mutual fund has done compared to the S&P 500 and the Dow Jones Industrial Average and other mutual funds in the same category. Make sure your mutual fund choice is doing at least as well as the major index funds.

Get a Prospective. If you plan on investing in a mutual fund, request a prospectus! The prospectus will disclose any risks taken with your money, amongst other very important topics.

Diversify. The old saying is true; don’t put all of your eggs in one basket. Never put all of your money in one company, and it’s probably not even a good idea to put it all in one mutual fund. Even if you think you have found the best investment in the world, something could always happen to it. When choosing mutual funds, make sure they are not all in the same sector, the same market capitalization, or even the same economy. You’ll want a good mix of investments in different sized companies in the US and abroad.

Not all mutual funds are the same. Be sure to choose the best mutual funds for your investing goals. Learn what to look for and how to avoid common problems that many beginning investors make.