Money Market ETF Not as Safe as it Appears

Updated from Nov. 21.

PowerShares has come out with an exchange-traded fund designed to act like a tax-free money market fund, but it's not quite the low-risk investment it appears to be.

The VRDO Tax-Free Weekly Portfolio (PVI Quote) tracks the performance of a pool of variable-rate demand obligations, or VRDOs, which are long-term, fixed-rate municipal bonds that act like short-term floating-rate notes.

They are popular with money market funds because they yield slightly more than some other short-term instruments, like Treasury bills and certificates of deposit, and have widely been perceived as safe.

VRDOs act like money market instruments because investors can demand repayment at par with seven days' notice. Also, the interest rate on the notes is reset each week at prevailing money market rates. This interest, which is paid out on a monthly basis as dividends, is exempt from federal tax. Depending on where you live, it may also be exempt from state tax.

In the past, they have been considered relatively safe because many of the municipal bonds are insured, and the issuers' ability to repurchase them is typically also guaranteed by a letter of credit from a bank.

PowerShares says PVI pays about 3.5% pretax, which would equate to a 5% after-tax yield. The ETF tracks the Thomson Municipal Market Data VRDO Index and charges an annual expense ratio of 0.25%.

PowerShares expects PVI will have a lot of appeal with institutional investors as place to park money for short periods of time and earn tax-free interest. "It's weekly paper with guaranteed principal," says John Southard, a managing director. "It's not risky at all."

(The Securities and Exchange Commission has since asked for clarification as no investment is risk-free. "Obviously, I didn't mean it has no risk," says Southard. "I meant compared to other investments, it's lower risk.")

Typically, that's true. But these are not typical times for municipal bonds or the broader credit markets. "VR" could stand for "very risky" with all the trouble brewing.