If you peruse the lists of funds available at large mutual fund companies such as Fidelity or Vanguard, you’ll quickly discover some rather intriguing “investments” called money market funds.  They are offering current yields of 0.01% to 0.09%.  At that yield, per the rule of 72, it would take you up to 7200 years to double your money.  That doesn’t seem very attractive.  In fact, it hasn’t been in recent years.  What I consider to be one of the premier money market funds in the world, the Vanguard Prime Money Market Fund has a one year return of only 0.08%.  How in the world does a fund stay in business offering such a pathetic return?

Why Would an Investor EVER Invest in a Money Market Fund?

The History of Money Market Funds

To answer this question, you need to go back to the 1970s.  Imagine if you will, a world where inflation seems to go up every year.  By 1978, inflation was 11.3% per year.  Meanwhile, banks were so heavily regulated, that not only could they offer no interest on checking accounts, but there was a cap on the interest rate they could offer on their savings accounts.  Prevailing short term interest rates, as dictated by The Fed, were nearly 10% in 1978.  Banks could not attract the capital they needed to make loans because the government didn’t allow them to offer the market rate (AKA a fair rate) to their depositors.  The banks tried to compete by offering free toasters and even televisions to those opening new accounts.  Their depositors, naturally, started looking elsewhere for improved yields.  The most obvious place to look was money market funds.

Money market funds were offered by mutual fund companies and regulated not by bank regulations, but by mutual fund regulations.  They were free to offer the going rate on money, so they did.  Investments flocked in.  As the banks started circling the drain, there was great pressure on Congress to deregulate the banks, and between 1978 and 1982, they were freed to offer any interest rate they chose.  But by then market money funds were already a well-established industry. Since that time they have competed quite favorably with the best savings account interest rates, until recently.  To understand what happened, one needs to understand what a money market fund is.

Savings Accounts vs Money Market Funds

A money market fund looks to the investor like a savings account.  You send the fund money which you can demand back at any time.  The fund, in turn, loans it out.  Each month you get a dividend (smells like interest, no?)  You can even write checks and do direct deposits and payments.  But once you look under the hood, you realize it is quite a bit different.  In a savings account, the bank guarantees your principle, and pays you the interest it has announced for a particular time period, usually a month.  The bank gets to decide how much interest it will pay based on how much money it needs to lend out.  When the bank funds get low, it raises the interest rate on its deposits.  When funds are high relative to loans, it drops the interest rate on deposits to maximize profits.  To make things confusing, banks also have “money market accounts.”  These are just savings accounts with some additional restrictions and a slightly higher interest rate to compensate for them.

A money market fund is much more complex.  Take the Vanguard Prime Money Market Fund for instance.  Like any mutual fund, it accepts new funds from investors and invests them according to its investment policy.  It invests in all kinds of short-term debt investments like treasury bills, bank CDs, commercial paper, and yankee bonds.  Bills are just government bonds with a maturity of less than one year.  Bank CDs are exactly the same as you and I can buy at the bank, but they’re obviously usually for larger amounts, and are often longer-term CDs that are soon to expire bought on the secondary market.  Commercial paper is an unsecured loan from a bank or a corporation to meet its short-term borrowing needs, 270 days or less.  Yankee bonds are bonds issued by foreign banks or companies in the US, particularly when US interest rates are low, like now.  Money market fund regulations dictate that no more than 5% of the fund can be in any particular investment, no investment can have a maturity longer than 13 months, and the average maturity must be less than 60 days. In order to make money market funds seem to investors like bank accounts, they keep the share value constant at $1.00 and pay dividends that seem just like bank interest.  But the fact remains that the share value fluctuates above and below $1.00 every day because the value of the underlying assets fluctuates with the market.  So the $1.00 share price is really just a mirage.  But in order to preserve the mirage, mutual fund companies are willing to step in with their own assets when things go a little sour, and only 2 or 3 examples exist of a fund “breaking the buck.”  But the truth is they all break the buck every day, they just don’t tell you.

Sources of Return

So what determines the return on a money market fund?  Three things.  First, the main factor is The Fed.  The Fed sets two important interest rates, both of which have a large impact on short-term interest rates, and a much smaller impact on other interest rates.  The Federal Discount Rate is the rate at which a bank may borrow directly from the Fed.  It is currently 0.75%.  The Federal Funds Rate is the rate at which banks may borrow from each other on a very short-term basis (usually overnight).  It is set at 0.25%.  Now why do banks borrow from each other overnight all the time?  Banks have a reserve requirement dictated by the government.  The government can change this from time to time, and it varies a bit by the size of the bank.  But for larger banks, the requirement is 10%.  If they accept $100 Million from borrowers, they can only loan out $90 Million.  Obviously, to be as profitable as possible, you don’t want to keep a cent more than $10 Million on the books.  So with the daily transactions, you may find you’re a little short of the requirement or you have a little too much.  Those with too much loan it to other banks.  Those with too little borrow it.  At what rate do they borrow it?  0.25%- The Federal Funds Rate.  If they can’t find another bank to borrow from, they have to go to the Fed where it is generally more expensive.  So if banks can borrow from each other at 0.25%, they are willing to loan money out at just about any rate more than that.  0.3%?  Sounds great.  0.5%, even better.  When you’re talking about millions, even a small percentage really adds up.

The second factor that affects the return of a money market fund is the management cost.  A fund that operates at a lower cost can pass that savings on to its investors.  This is the reason Vanguard has been so successful over the years, particularly with its money market funds and bond funds.  As a mutually owned mutual fund company, all profits benefit the investors themselves, in the form of lower expenses on the funds.  The less paid to manage the fund, the better its return.  Even better, a fund with lower expenses can take less risk and still have the same return as other funds.

The third factor that affects the return of a money market fund is the skill of the management team. Should they invest in CDs or yankee bonds?  The commercial debt of automakers or of oil companies?  Push the maturity out to 60 days or keep it closer to 30 days.  This is all dancing around the edges, and is dwarfed by the management cost as a factor, which in turn, is dwarfed by the actions of The Federal Reserve.

Why Yields Are So Low in 2011

So now, with the Fed keeping interest rates at 0.25%, most of the assets that money market funds are allowed to invest in pay little more than that.  When you subtract out the expenses of the fund, you’re left with the puny yields you see today.  Savings account interest rates are set by a different process, so they can at times be quite a bit higher (and also quite a bit lower) than the yield on a money market fund.  Right now, with short-term interest rates at nearly zero, they are obviously higher. The usual suspects for the best savings account rates, online banks such as Ally Bank, ING, and HSBC, offer yields of about 1%.  It’s not much, and it is well below the 3.2% current inflation rate, but it is far better than what money market funds are currently offering, which is essentially 0%.

[Update 2017: I see the Admiral Shares for Prime MMF are now offering a yield of 0.85%, closing in on the 1% offered by an Ally High Yield Savings Account.]

Why Do MMFs Still Exist

So why is there any money in these funds at all?  Inertia is certainly one reason.  I’ve still got $400 sitting in Vanguard’s Prime MMF.  Most of my short-term cash is at an online bank, but I haven’t gotten around to moving the last little bit.  I figure it probably isn’t worth the hassle for $4 a year.  Some people have money in a money market fund because they use it as a sweep account for their ETF or stock trading.  Still others want a portion of their IRA in cash, and since it requires a significant amount of paperwork to move IRA money from one institution to another, they choose to leave it at the mutual fund company.

When (if?) short-term rates increase to historical norms, money market funds will again be competitive with the online savings banks and will make your local bank’s rates look pathetic.  But until then, there is no reason to keep any significant amount of money in a money market fund.  Not only does it pay less but the principle isn’t guaranteed by the FDIC as it is at a bank.  (Although there is a temporary guarantee on some money market fund assets invested prior to the 2008 financial meltdown.)  Money market funds are riskier than bank deposits (at least up to the FDIC limits) and you shouldn’t invest in them unless you are adequately compensated for that risk.  They can and have “broken the buck.”

How to Get A Higher Yield on Your Savings

If you’re really looking for somewhere to put a small amount of cash with a decent yield, I think your best bet these days is probably a high-interest checking account.  These are relatively new, and have requirements such as 12 debit card transactions a month, but are currently offering yields of 1-4%, but only on amounts up to $10-25,000.  In my opinion they have been instituted to try to get some of the reward credit card business, but either way, you won’t be losing much in the way of credit card rewards by making a few small debit card transactions every month.  If you really wanted to go to the trouble, you could put $25,000 in the account and use the card for 12 redbox transactions.  At a certain point, you’re better off just seeing a couple more patients with your time rather than dealing with all these little checkboxes.

What do you think? Do you invest in a money market fund? Why or why not? Comment below!