One True Thing: Money Market Funds

In a year when the typical domestic stock fund is down an average of 6.50%, it's no wonder that many investors are looking to the security and steady incomes of money market funds.

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One True Thing: Money Market Funds

Money market funds, which invest in short-term debt instruments like government or municipal bonds, are safe, liquid investments that are ideal for people who need to store some cash that they'll need in the near term. Unlike investing in stock funds, money market funds yield a steady return, which makes them popular alternatives to savings accounts or as a place to park cash during times of stock market volatility.

And in times like this, when the stock market is particularly rocky, that return can be attractive. The average seven-day compound yield of money market funds was 5.25% for the week ended Feb. 27, according to Money Fund Report, a publication of iMoneyNet. And the "idle cash" rates available in brokerage accounts, which usually sweep this money into money market funds, were not far from that (for a list of what rates online brokers are currently offering, click here).

Although the returns of money market funds will never soar to the highs of tech funds, investors have been taking notice. U.S. money market funds took in a net $3.49 billion for the week ended Feb. 27, bringing the total amount of money market assets to a record $1.98 trillion, according to Money Fund Report. Other recent fund-flow data confirms the renewed interest in these meekest of investments.

Ironically, the Federal Reserve's rate cut earlier this year, which has sent the seven-day compound money market rate down to 5.25% from 6.14% at the beginning of the year, has prompted many institutional investors to go into money market funds, says iMoneyNet vice president and managing editor Peter Crane. That's because money market funds usually react more slowly to a Fed rate move than the underlying investments themselves. Crane estimates that it takes a month and a half before a Fed rate move is reflected in money market funds.

"The hot money will move into money funds because the yield drops more slowly," Crane says.

The stock market's volatility over the past year also has many institutions and individuals alike sidelined in money market funds as they wait for an opportune time to get back into the market.

"You're seeing a lot of movement into all sorts of fixed income, because people are looking at last year's figures and seeing how well bond funds performed compared to stocks," says Morningstar senior bond fund analyst Eric Jacobson.

How to Choose a Money Market Fund

If the stock market's gyrations are getting to you, and you're considering putting some assets in money market funds, one of the most up-to-date sources for current money market yields is iMoneyNet's site, which ranks the top-yielding government, nongovernment and tax-free money funds for retail and institutional customers.

In choosing a money market fund, the single most important factor for investors is the expense ratio, which can easily eat away at a fund's return. Because the market for money market funds is so large, liquid and efficient, there isn't a big difference in yields from one product to another, explains Morningstar's Jacobson, so choosing a money market fund with a low expense ratio will be key to the fund's performance.

The rankings on iMoneyNet's site take into account expense ratios so investors have a clear idea of what a fund truly yields compared to its competitors, says Crane. The average expense ratio for money market funds is 0.5%, but many fund companies offer fees that are much less than that, and some often waive their expense fees to attract new customers, Crane says.

The catch with that is sometimes companies begin charging a fee again after a period of waiving them. Crane says investors should just be aware of that and notice if their money market yields are dropping below the category average. If they are, that could be a sign that the company is charging above-average fees.

Crane also notes that when it comes to money market funds, many individual investors are more concerned with the features of the account -- such as how many checks they can write on the account each month -- than they are with yields.

A Note of Caution

While money market funds sound good right now, Morningstar's Jacobson warns that too much safety is not always a good thing for investors. Before you run out and put half of your assets in a money market fund, think of the old adage: Past performance is no guarantee of future returns. Sure, money market funds outperformed normally high-octane investments like large growth funds last year, but that might not be the case at the end of this year, or even six months from now, especially now that the Federal Reserve is in rate-cutting mode.

"It doesn't make sense to go crazy filling up on them now, especially since returns are going to taper off," says Jacobson.

Jacobson advises most investors to keep about three to six months of income stashed in a money market fund for emergencies, because most people who are investing for the long term don't need much more than that. Plus, when the stock market does turn around, investors need to be in the market to reap the benefits.

"The positive side of it is that people are getting reminded that there is a place in their portfolios for money market and bond funds," says Jacobson. "The best advice is not to swing the pendulum back the other way."