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.

The exodus began during the financial crisis when investors feared losses. Since then, shareholders have continued leaving money-market funds in search of higher yields.

Yields on money funds remain minuscule. According to Crane Data, the average yield is 0.06%. That skimpy payout is not likely to rise anytime soon because the Federal Reserve is committed to keeping short-term rates low at least until 2014.

Even with their tiny yields, money-market funds can still serve an important function for investors who want a convenient parking place for cash. But for safety, stick with funds offered by companies with deep pockets, such as Fidelity Investments or Vanguard Group. If those money-market funds run into trouble, you can bet that the parent companies will bail out shareholders rather than suffer negative publicity.

To boost the returns of your portfolio, keep as little as possible in money markets. If you are willing to tie up funds for a year, you can get yields of 1% on bank certificates of deposit, which are insured by the FDIC.

To do better than that, you will have to take on risk.

A sound option is to shift some money to ultrashort bond funds. While money-market funds must have average weighted maturities of 60 days or less, the ultrashort funds focus on securities with maturities of one or two years.

During the financial crisis, many of the ultrashort funds were slammed when mortgage securities crashed. But these days funds that focus on high-quality investments offer plenty of safety.

A sound choice is William Blair Low Duration ( WBLNX), which has a current yield of 1.28%. The fund keeps most of its assets in government-backed securities with AAA ratings. The fund has a duration of about one year. So if interest rates rise by one percentage point, the fund could lose 1%.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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