The easy way to keep your head above water this year in mutual fund investing has been to own a money market fund.
Now yielding 6 percent at an annual rate, money funds are paying off almost as well as the average stock or bond fund without those markets' jarring ups and downs.
More than 70 percent of the way through 2000, the average stock fund tracked by Bloomberg has gained about 5 percent and the average bond fund about 4.7 percent. Stretched out over a full year, those translate to annual returns in the 6.7 percent to 7.3 percent range.
Against this modest competition, money funds have proved more popular than ever. Their assets have climbed to new highs of $1.75 trillion, according to the Investment Company Institute.
That's more than twice the $800 billion that investors now have in bond funds. Just seven years ago, bond funds were bigger than money funds, which specialize in securities with lives of less than a year, such as commercial paper.
Investors have made their preference plain. When they look for a counterweight to their huge stock fund investments, they opt for a money fund, with its constant $1 net asset value per share, rather than a bond fund, whose NAV fluctuates constantly with bond prices.
Who's to argue with that choice? I've always had a fondness for money funds myself, in any situation where stability and preservation of capital were the order of the day. As time has passed I've encountered a lot of those situations.
Though money funds lack the government backing that federally insured deposits can offer, I count them as highly safe. It's also prudent, though, never to forget money funds' limitations.
"While many people regard cash (money market investments) as being a risk-free asset, this is only true for people with limited short-run objectives," says David Kelly, economic adviser to Putnam Investments, on the $398 billion money management firm's Web site at www.putnaminv.com.
Here are two troublesome ways in which money funds can surprise you:
Their yields may fall very quickly in periods when short-term interest rates decline, and their long-term returns can be very disappointing after taxes and inflation take their cut.
Back in 1990, the Vanguard Prime Money Market Fund, one of the biggest of the breed with $45 billion in assets, yielded 8.3 percent. Then the return fell to 6.1 percent in 1991, 3.7 percent in 1992 and 3 percent in 1993 as the Federal Reserve lowered short-term rates to stimulate the economy.
Here in 2000, the Fed has been raising rates since the middle of last year, not lowering them. But it could change direction pretty quickly if the economy slowed more than expected say, if whopping heating bills this winter put a sudden damper on consumer spending.
As for inflation, the real return on money funds, or their yield minus the inflation rate, has been generous in recent years. Vanguard Prime's returns of 5 percent in 1999, 5.4 percent in '98 and 5.4 percent in '97, all were more than double the same years' increases in the consumer price index.
But back in '92 and '93, the fund's returns barely beat CPI increases of 3 percent. In 1980, when Vanguard Prime had a total return of 13.1 percent, the CPI increase was even higher, at 13.5 percent.
Over long periods, money fund returns usually come in far short of the payoffs from stocks. In the 10 years through mid-2000, Vanguard Prime averaged a 5.1 percent annual return, while the Vanguard 500 Index Fund, modeled on the Standard & Poor's 500 Index of stocks, averaged a 17.6 percent return.
The comparison is worth making, because money stashed "temporarily" in a money fund has a way of turning into a long-term investment as you wait, wait, wait for just the right time to put it into stocks.
Quite possibly stocks in the next 10 years won't approach their record in the last 10. But it may also be that they'll still outperform money funds handsomely. The uncertainty in stocks is the price you pay for the chance at that bigger reward.
Or to put it another way, the supposed certainty you find in money funds can cost you plenty in opportunities missed.
Chet Currier is a columnist for Bloomberg News.
For reprint and licensing requests for this article, CLICK HERE.
Stories You May Also Be Interested In
- Chet Currier---Conservative Investors Find Strategy Remains Effective
- Chet Currier---Bond Funds Benefit Increasingly Risk-Averse Investors
- Chet Currier---Biting Into Unappetizing Funds May Prove Profitable
- Chet Currier---In Financial Planning, Assume Stocks Won't Cooperate
- CHET CURRIER---Bonds Have Taken a Beating but Now Show Promise
- Chet Currier---Make Resolution to Diversify as Business Year Begins