Money Markets 101

07/22/2005 12:00 am EST

Focus:

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Few consider money market funds as part of their investment education. Dan Wiener, the leading expert on Vanguard funds, believes an understanding of the role of money markets in your portfolio planning is a critical component in successful investing. 

"Money markets, the Rodney Dangerfields of the investment world, are suddenly earning a bit more respect from—and bigger returns for—investors these days. Yup, money market funds are back with a vengeance, and you can thank the Federal Reserve and a growing economy for that. Since the Fed began hiking short-term interest rates one year ago on June 30 2004, the yields on money funds have been working their way higher and higher.

"Money funds have never really gotten the respect they deserve. For most investors, a well-balanced portfolio has a foundation in the three basic asset classes of stocks, bonds and cash. To say that only bonds and stocks matter is like offering someone a seat on a two-legged stool—it just doesn’t stand up. In addition, given how flat the 'yield curve'is right now, you have to take on exponentially greater risk to boost yields by a mere one percent, hardly a winning proposition.

"So let’s talk money funds. First, you always win the cash game at Vanguard (1-877-662-7447). Its money funds are so low-cost and so safe, that it’s a no-brainer when it comes to deciding where to stash your cash. There’s no better place for Vanguard to strut its low-expense stuff than in a money fund where every penny saved is a penny that drops straight to the bottom line and into the shareholder’s pocket. Okay, I’ll admit money funds can be boring, with a capital B.

"Net asset value on a money fund? One buck. Never changes. Never will. Boring. Real boring. I mean, how much excitement can you muster over short-term, interest-bearing, high-quality commercial paper and other super-safe securities that mature in 90 days or less? Snore. Now, I’ll grant you there’s always the possibility for scandal or malfeasance or downright stupidity on the part of a manager that could lead a money fund’s price to fall below $1. But that’s not going to happen at Vanguard.

"I don’t believe money markets are investment vehicles. I do believe, though, that they are a valuable financial tool and an important part of your investment plan. For my money, cash will never be king. Yes, it did produce a better rate of return than most of my stock funds over many months in 2001 and 2002. But in my investment lifetime and yours, it’s almost a certainty that the returns from a money market fund will fail to match inflation, hence eroding the value of our savings. No, I don’t consider cash a kingly investment. But cash in a money market fund is a wonderful risk reducer. It can take the edge off of the volatility in your portfolio.

"Even investors who think they should be 'fully invested' can benefit from a money fund’s stability. And reducing loss by even one or two percent can often make the difference between simply hitting a pain threshold, giving up and bailing out of the market, or sticking with their proscribed investment plan. That’s why I often allocate a percentage of my private clients’ accounts to a money market (or slightly higher yielding short-term bond alternatives). We make good returns when markets are roaring and preserve assets a bit better when markets are falling.

"It’s all in the mathematics of losses and gains. It takes a 25% gain to make up for a 20% loss. If my cash holdings buffer my portfolio and keep that loss to 15%, I’ve significantly reduced my downside risk and I’ll only need an 18% gain to get even. Of course, if the market roars, that cash will hold me back. But at least I’ll still be in the game. So, cash is neither trash, nor king. It’s a tool. And probably the number one hardware store in the money fund universe can be found at Vanguard.

"Why own them? Here’s why you should have a Vanguard money fund. My arguments haven’t changed over the years, yet I still see investors who keep their money in a low-to-no yield bank account or one of the many lower-yield, higher-expense money funds that abound in the fund industry. So, let’s go through the reasons again. Forget the investment uses and implications for a moment. Your money fund is a high-yield alternative to bank savings and checking accounts.

"A simple call to Vanguard and you can wire money from your money market to just about anywhere. If someone is sending you money, a wire into your money market means you’re earning interest on that cash immediately. That’s just smart cash management. Plus, when funds pay out distributions, you can have Vanguard automatically deposit all your distributions into the money market fund. You can also have monthly bond fund payouts sent directly to a money fund if you wish, making them instantly available should you care to write a check on them.

"Having at least a portion of your assets in cash is simply a prudent and useful money-management tool. I think of my cash holdings as a shock-absorber for the rest of my portfolio, as I mentioned above. Why? First and foremost, money market funds are safe, safe, safe. They simply don’t lose money. Second, if you’re like me, you occasionally need to extract some money from your Vanguard investments to help pay the bills. The check-writing privileges on money market funds make them incredibly convenient.

"And, writing a check on a money market fund doesn’t create a taxable transaction that must be reported to the IRS, unlike a check written on a bond fund. When you need to liquidate some bond or stock fund assets you can do so in nice, round numbers and have the money transferred into your money market. From there it’s easy to write the checks you need. I’ve done this many times. Third, money market funds are useful if you follow a dollar-cost averaging, value-averaging or other systematic investment plan. Your money continues to earn interest, remains completely safe, and can usually be moved with ease into another fund with a single phone call or a visit to Vanguard’s web site. 

"Fourth, investors who want to gradually change the allocation of their portfolio can use a money fund for just such a purpose. For instance, an investor with stock and bond funds who wants to gradually build up cash reserves can instruct Vanguard to automatically deposit all dividend and capital gains distributions directly into a money fund, rather than reinvesting them. This can make your life easier at tax time since you won’t have all those odd, reinvestment transactions to account for. And it will help you slowly build the cash position in your portfolio. Oh yes. There’s one more thing. Cash is a good rainy-day asset. When you believe that the market pendulum has swung too far to the bearish side, cash gives you buying power. Meantime, while you wait, the money market fund is paying you interest.

"Remember, money markets are not investments. Despite the fact that there will be periods where money funds outperform stock funds, they have traditionally been unable to outpace inflation. They can look smart. But cash is a volatility buffer, not a return booster. As long as our objective is to have some safe, liquid money available to us, then cash, and Vanguard’s money funds in particular, are the ultimate money holding vehicle and one of the three important legs on your portfolio stool."

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