Don't Laugh, Money Market Funds May Be the Smart Money

If you mentioned in 1999 that money market funds were in your portfolio that year, you'd get laughed out of the room. If you mentioned that this year, you might still be laughed out of the room -- but your portfolio would look a lot healthier than those of the folks who are laughing.

These funds, which offer slow but secure growth via investments in corporate and government debt, have been unloved during the recent heady years of the bull market. But thanks to a combination of rising interest rates that have pushed up the returns, and increased competition that has pushed down the fees, money market funds look to be one of the best bets this choppy, volatile market has to offer.

The average money market fund is yielding an annual rate of 6%, the highest level since April 1991, according to iMoneyNet, a savings and borrowing information service. That's almost as good as your average stock or bond fund, but it avoids exposure to the vagaries of the markets.

The primary reason for the increase in returns is interest rates , which the Federal Reserve boosted six times in the past 18 months, says Connie Bugbee, editor of iMoneyNet.

The money market funds arena is far less complicated than other corners of the fund world. There are two fundamental types of money market funds: taxable funds and tax-free funds, which offer higher returns with taxes offsetting some of those gains. (For more information, see the Investing Basics primer on money market funds in the mutual funds section.)

The best thing about money funds is that they are virtually risk-free. Essentially, they are mutual funds that invest in short-term debt, and that usually means unexciting rates of return. But fund companies and banks, the primary sources for these instruments, are spicing up their offerings.

In a bid to court new cash into money market funds, many fund companies are waiving all or some of their fund fees. They hope these incentives will encourage investors with spare cash to buy into stock or bond funds in the same fund family, says Peter Crane, vice president and managing editor of iMoneyNet. "No one makes a lot of money from running money market funds, but they present excellent prospects for cross-selling other investment products."

And given that fees typically account for 90% of a money market fund's return, they can dramatically increase yield, says Crane. The money market fund is the only type of fund where if you waive all the fees you can buy a No. 1 ranking, he adds. "It has a halo effect because people see that a money market fund is No. 1 and get a warm fuzzy feeling. They don't recall if it's the money market fund or the stock fund."

A case in point is the Zurich Yieldwise Money Fund, which has beaten all other general money funds over three years, according to Lipper. The fund has an annualized yield of 6.42 % and has aimed to build assets by waiving the cost of expenses, says Frank Rachwalski, lead portfolio manager for money funds at Scudder Kemper Investments. "We won't do it forever, just until we have built a sufficiently sized fund," he says. "It's at $340 million now, but we'd like to see it go to $1 billion."

A reason for the push is the saturation of mutual fund investments. Almost half of all U.S. households hold investments in mutual funds, says Crane, so fund companies are going after bank markets and waiving fees to attract investors.

In fact, competition is rising in the money market world. At banks, money market accounts, which can be used like a checking account but restrict users to six transfers a month, are feeling the heat from Internet banks that have started offering higher rates on savings, says Crane. In return, banks, which also sell money market mutual funds, have become more competitive.

"Banks are beginning to compete more aggressively with their money market accounts, and soon you won't be able to tell the difference between these accounts and money market funds," says Crane.

Aside from fees, some money market funds invest in longer-term debt to increase their gains, but this also increases the risk of the investment, says Sarah Bush, mutual-fund editor at MorningstarAdvisor.com. Some invest in corporate debt, a riskier investment that produces greater gain, instead of government-backed debt.

The question is whether all this is good news for investors? It is, says Crane. "There is no reason to refuse a good yield, and one hopes that they will introduce fees back in slowly," he says. "And when the yield drops, you can simply move to another fund."