Money-Market Funds Face an Uncertain Future

NEW YORK (TheStreet) -- Money-market funds are "well-executed fictions," writes Don Phillips, Morningstar's president of fund research. The illusion centers around the fact that the funds always price their shares at $1.

As a result, investors view money-market funds as interest-bearing checking accounts that can never lose money. In fact, the funds hold portfolios of fixed-income assets that can default.

According to the Securities and Exchange Commission, there have been hundreds of instances when funds have faced losses. In nearly every case, shareholders remained untroubled by the dangers because fund companies stepped forward to make the funds whole and preserve the image of security.

Morningstar's Phillips argues that the rescue operations have served investors well. "These funds are a wonderful convenience that benefits millions of investors, few of whom would like to see the script altered in any way," he writes.

Now SEC Chairman Mary Schapiro wants to end the fiction. Under an SEC staff proposal, the price of money-market shares would no longer be fixed. Instead, shares would rise and fall along with the value of holdings in the portfolio.

Fund companies have howled in protest, saying that the new rule would cause many shareholders to dump their funds. The industry's fears are undoubtedly justified. If money-market funds can routinely fluctuate, then investors will shift to real bank checking accounts.

Republicans in Congress have vowed to block the new rules. So any changes this summer are unlikely. But if President Obama is re-elected, then the new rules could be imposed. Schapiro says floating rates are necessary to avoid a repetition of the trouble that occurred in 2008 when the Reserve Fund faced defaults and "broke the buck."

In response, institutional investors dumped their funds. The markets only calmed after the Treasury stepped forward and agreed to back up money-market funds.

No matter what Washington decides, money-market funds are likely to shrink. In recent years, investors have been dumping the funds. Total assets in the funds have fallen from $3.8 trillion in 2008 to $2.5 trillion now, according to the Investment Company Institute.

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