Money Funds: Moving to the Red Zone?

If rates go any lower, standard fees may begin to eat up gains this year. Money-market managers could waive fees -- but only for a while

By Amey Stone

If interest rates continue to fall, money-fund investors may find themselves in rare territory indeed for investments associated with low risks and low yields: They may actually see negative returns this year. So far in 2003, the average money-market fund has yielded just 0.7% on an annualized basis, net of fees, which average 0.6%, according to researcher

All it would take to push most funds into the loss zone is for the Federal Reserve to cut interest rates by an additional 50 basis points (or 0.5%) at its June meeting. Then, the average fund's yield could fall to 0.2% net of fees. Theoretically, on a money-fund investment of $10,000, the average investor would net just $20 after paying a fund company $60 a year in fees.

The real blow of a further rate cut would be to investors in funds that charge above-average expenses. Some 8.4% of the $2.12 trillion in money-fund assets is in funds that yield 0.5% or less. About a quarter of that group yields 0.25% or less. (Those are mainly funds offered by full-service brokerages, so they have extra marketing and sales charges layered in.) These funds could end up paying nothing to investors -- or worse yet -- effectively charging customers a small fee for keeping their cash in a safe place.


  Already, some money-market funds that are part of variable annuities or 401(k) plans (where an account-management fee is added on top of the money-fund fees) are posting negative returns net of fees. Take Trip Jones, a managing director at SunGard Institutional Brokerage. In the first quarter of 2003, he was disheartened to see the return on the money fund in the 401(k) at his prior firm was -0.12%. At the time, Jones was captive to the 401(k) plan, so he couldn't just choose another money fund or withdraw his stake. But customers who are free to move their money would probably do so if returns went negative, he figures.

Rather than have that happen, most funds would likely respond to new lower rates by cutting their fees so returns would stay at least slightly positive, says Peter Crane, vice-president of iMoneyNet. In fact, most fund complexes already make it a practice to waive a portion of their money-fund fees to keep rates competitive, with some assuring investors of at least a 0.25% yield. The number of funds partially waiving fees is now up to 60%, up from 58% a year ago.

"We would never allow negative yields on our money funds," says Stephen Ward, chief investment officer for Charles Schwab Investment Management, which has several money funds yielding 0.54%. Although he says the firm is monitoring money-fund rates closely, "There are so many moving pieces to this -- what the Fed does, what markets would do in response to Fed, what the competitive forces would be in the money-fund industry," that he thinks it's premature to conclude money-fund rates will be forced much lower.


  So far, the industry is showing little panic, but the notion of negative returns could become a serious issue if the trends don't turn around by the end of next year. "A lot of fund providers have been waiving fees and hoping the issue will go away," says Crane. "But that may be wishful thinking." Fund companies forced to waive a bigger portion of their fees may find they can't operate profitably. Continuing to offer the funds as a service to investors would then crimp overall earnings.

Another possible scenario: If funds stop waiving fees and customers pull their assets out in favor of bank deposits -- which, unlike nonbank funds, are FDIC insured -- or other alternatives, the money-market-fund industry could wither. "It's going to get to the point where the biggest marketplace for these types of products isn't going to exist anymore," says Steven Shachat, who manages the top-yielding Alpine Municipal Money Market Fund, which launched last December. "You'll have underwriters who want to issue paper at extremely low rates, and they might not have an audience."

A gradual erosion of money-fund assets is already taking place as investors switch to higher-yielding bank-deposit accounts. "Outflows haven't been large, but more important, inflows have dried up," says Crane, who says prior to 2002, money-fund assets had been growing at a rate of 15% a year. "If the Fed Funds [rate] remains below 1.25% for less than a year, I expect there to be a minor impact on the structure of the industry," says Crane. "If it turns out to be five years, that may change."


  For now, individual investors still have the option of switching into higher-yielding money funds. Alpine's tax-exempt fund, for example, has a seven-day effective yield of 1.27%, making it the top-performing money fund -- an anomaly for a tax-exempt fund, which typically yields less than an equivalent taxable fund. Also, many of the highest-yielding bank money-market accounts return better than 1.2% a year. Top money-market account rates available include 2.33% for the Bank of Internet and 2.1% for ING Direct.

For most people, as long as they're still seeing some gain -- even a tiny one -- it isn't worth the trouble to move assets out of their money funds, especially if they plan to use the savings soon or hope to reinvest it in stocks when the economic clouds clear. "Unless you're getting more than a full percentage point in an upgrade, it's probably not worth the inconvenience of making a switch," says Crane. "If you're talking about less than $20,000, don't even bother."

If the economy keeps limping along for years and the specter of deflation becomes real, Crane thinks the market might come full circle. Investors might be willing to pay a fund company for the convenience and safety money funds provide. "Investors may eventually live in an Alice in Wonderland world where they're happy to have only lost 0.5% on their cash," he says.

That may sound farfetched now. But if the Fed lowers rates again at its June meeting, the scenario is well worth considering seriously.

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Patricia O'Connell