Don’t Knock Money Market Funds

06/19/2007 12:00 am EST

Focus:

Daniel Wiener

Editor, The Independent Adviser for Vanguard Investors

Dan Wiener, editor of the Independent Adviser for Vanguard Investors, says cash isn’t trash, explaining the important roles money market funds play for investors.

With the Federal Reserve having hiked rates with a vengeance, from 1.00% to 5.25% between June 2004 and June 2006, yields on money funds have risen and stayed high.

Take a look at Prime Money Market (VMMXXX), typically Vanguard’s highest-yielding money fund. Beginning last July, after the Fed’s 17th rate hike, Prime’s yield crested over 5%, where it remains today.

Vanguard hasn’t left tax-free income seekers out in the cold. The Vanguard Tax-Exempt Money Market’s (VMSXX) yield has risen close to 3.8%, which is equivalent to a taxable yield of 5.1% for someone in the 25% federal income tax bracket and 5.8% for someone in the 35% bracket. Not bad!

Still, money funds have never really gotten the credit due to them. For most investors, a well-balanced portfolio has a foundation in the three basic asset classes: stocks, bonds and cash. Plus, given how flat the “yield curve” is right now, money funds look fabulous. If you want to boost yields over money funds by, say, one percent, you are going to have to take on exponentially greater risk. That just wouldn’t be prudent.

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 investors hitting a pain threshold, giving up and bailing out of the market, or sticking with their prescribed investment plan.

I think of my cash holdings as a shock-absorber for the rest of my portfolio, as I mentioned. Why? First and foremost, money market funds are safe, safe, safe. They simply don’t lose money.

Second, 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.

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.

Fourth, investors who want to gradually change the allocation of their portfolio can use a money fund for just such a purpose.

And there’s one more thing: cash is a good rainy-day asset. When the stock or bond markets take their hits and you believe that the market pendulum has swung too far to the bearish side, cash gives you buying power. While you wait, the money market fund is paying you interest, which currently is a pretty nice number.

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