May 27, 2003

Money Funds: Moving to the Red Zone?

An excerpt from the May 21, 2003, edition of Busin

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 iMoneyNet.com.

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.

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