Last Updated Sep 27, 2009 8:36 PM EDT
As you're likely aware, money market funds try to maintain a consistent share price of $1. There is no guarantee that they'll be able to achieve that stability, but regulations that prohibit money market funds from owning anything except high-quality, short-term debt have largely enabled them to avoid losses that would result in a fund "breaking the buck" (i.e. its share price falling below $1) over the years -- for the most part.
Until last year, the only blemish on the money market fund industry's record was a small fund that broke the buck in 1994. To be sure, there have been a handful of funds that have stumbled, taking losses on investments that imperiled the $1 share price. But investor confidence in the stability of money market funds was of such paramount importance that the management company inevitably stepped up and made those funds whole -- injecting cash into the funds, for instance, so that the fund's investors did not absorb a loss.
But last year, the perfect storm that overwhelmed our global financial system also shook the money market industry to its core. When Lehman Brothers went under, it started a chain reaction that resulted in one of the industry's largest money market funds -- the $62 billion Reserve Primary Fund -- breaking the buck.
The Reserve fund was far from the only money market fund that found itself holding hundreds of millions of dollars of suddenly worthless Lehman Brothers debt, but it was the only one without the backing of a deep-pocketed parent firm that could provide enough capital to meet soaring redemptions.
It's a tribute to the importance of the money market fund industry that within days of the Reserve fund's collapse the Treasury Department instituted their guarantee program -- insuring the assets of all money market fund shareholders who were invested on or before September 19, 2008.
With assets of over $3.5 trillion, money market funds are the largest purchasers of commercial paper -- unsecured short-term debt that corporate America relies upon to fund their day-to-day expenses. With credit markets around the globe seizing up, the Treasury needed to prevent a run on money market funds from further choking off the flow of credit. Thus, the guarantee program was born.
So now that the program has ended, should money market investors worry? In my opinion, the answer is a qualified "No."
Of course, if you invest in a money market fund that invests exclusively in government issued debt, you have little cause for concern. (Indeed, one of the more curious aspects of the Treasury guarantee program was hearing fund managers try to justify paying to have their Federal money market funds participate in the program -- the Treasury was essentially selling insurance on its own debt.)
But if you choose to invest in a money market fund that owns corporate debt, you should use this opportunity to review your investment.
The first step in doing so is to remind yourself of the primary role of a money market investment -- to protect your assets. A money market fund is no place to be reaching for a few extra percentage points of yield. There are only two ways for a money market fund manager to increase his fund's yield: by lowering expenses (which many are doing today as interest rates are near zero), or lowering quality.
The latter is what got the Reserve Primary fund in trouble, as the manager loosened the quality standards on his fund in an effort to increase its yield. It worked for a while. The higher yield attracted assets, and the fund's assets more than doubled in a year. But the investors chasing that yield apparently never paused to wonder about its source, and ended up getting burned just a few months later.
So somewhat counter intuitively, you should be skeptical if your money fund's yield is suddenly rising in a stagnant interest rate environment. It could be a sign your manager is increasing the fund's risk profile. And if last year taught us nothing else, it taught us that there's more than enough risk to be had in the stock and bond markets, and there's no need to take any more on with your short-term savings.
Which leads to the second step in reviewing your money market fund: the behavior of your fellow investors.
Higher yields attract hot money. And if hot money is pouring into your fund in response to a higher-than-average yield, it will surely pour out as soon as it finds a higher-yielding alternative. But while the manager benefits in the interim from fatter management fees, buy-and-hold investors are stuck footing the bill for the increased level of transactions that this activity requires, a bill that reduces the return you earn on your investment.
In the end, the Treasury's money market guarantee program was probably meant to address investor emotions at least as much as any real danger of additional fund failures, which is why the fact that the program's end was met with a collective yawn was an encouraging sign that the credit markets are returning to normal. But that return to more normal times doesn't mean that your money market fund is immune from being harmed by dumb decisions in the future by your fund's manager.
So keep an eye on your money fund's yield and monthly asset totals. If either are suddenly rising, without any logical explanation, it may mean that you're taking on more risk than you should be.
Image via Flickr user yomanimus CC 2.0