Look beyond yield when buying money market funds
By Laura Bruce • Bankrate.com

The "D" word is bad news for money market funds. Federal Reserve chairman Alan Greenspan says the risk of deflation is somewhat remote but bears close watching. That could mean trying to head it off by cutting short-term interest rates at the next Federal Reserve Open Market Committee meeting.

A cut would cause money market funds, which are primarily composed of short-term securities, to drop their yields even further.

Average money market fund yields
The average seven-day yield on taxable money market funds is 0.70 percent after expenses, according to IMoneyNet. The average expense ratio is 0.60 percent.

"Sixty percent of money market fund companies are waiving a portion of their management fee, up from 58 percent a year ago," according to Peter Crane, vice president and managing editor at IMoneyNet.

"There are many that have a permanent waiver. They've been subsidizing some expenses, so it's tough to tell whether they're waiving or not. Some never intend to recoup the costs."

Money market funds are not federally insured, but they are regulated as to the quality, maturity and diversity of the securities in which they invest. Among the most common investments are short-term government securities and high-quality corporate debt. The goal is to maintain a $1 share price while trading securities to get the highest yield.

If the share price drops below $1, it's called "breaking the buck." This could happen if the fund's securities lose money. To date, only one money market fund has broken the buck; the fund was then liquidated. Breaking the buck is different than a negative yield caused by high expenses. But the result could be the same: Investors could lose principal.

Look for low-cost money market funds
The risk of losing money in a money fund may be remote, but consumers can avoid funds that walk closer to the danger line, and they can earn a higher return by looking for funds with very low expenses and top quality investments. Chasing money market funds with the highest yield isn't always a wise move.

"Most people see money market funds as a convenience," says Gary Arne, managing director of funds research at Standard & Poor's. "They don't think too much about it. The more knowledgeable look closer: What are the fees? What does the fund invest in?"

Morningstar analyst Scott Berry says the expense ratio is more important than the yield.

"The cheaper the fund, the more yield it can typically offer. A 1 percent expense ratio is at the high end. Vanguard's Prime Money Market Fund has a 0.33 percent expense ratio and yields about 0.90 percent. Another fund may have a 1 percent expense ratio and yield 0.30 percent.

"Also look at whether a fund is waiving a portion of its expenses as yields have come down. People should realize that the fund company may not do that forever. Look at their Web site or talk to a broker. There should be some kind of flag that points to a footnote saying a portion of the fee has been waived," Berry says.

Safety and quality ratings
Experts also advise looking for money market funds that hold securities with the highest credit ratings such as U.S. Treasuries or AAA rated corporate debt.

"Try to maintain short-dated securities that mature in 13 months or less," says S& P's Arne. "We limit the amount of floating rate securities they can buy. They have to keep 60 days average maturity for our highest rating."

S&P rates money market funds on the basis of credit quality and safety; fees are not taken into consideration.

As low as yields are, millions of people have opted to cut their stock market losses by stashing cash in money funds.

"People look at a nominal yield of 0.70 percent and say this stinks, but you have to pay attention to the alternatives," notes Crane.

"If other investments are going down by 10 percent, 0.70 percent doesn't look so bad."

John Bacci, financial planner with Foundation Financial Advisors in Linthicum, Md., uses money market funds as "no lose" accounts for clients who are fed up with the stock market. Even with inflation and taxes further eroding the minuscule return, Bacci says he prefers money market funds to the alternatives.

"Conservative investors are probably in the worst place right now. It's sickening how low yields have gotten. If you use a high-minimum-balance fund you can get them up around 1 percent, but you're just buying time until the equities recover. It's not so much of an investment choice as an investment of last resort.

"It keeps the client invested, otherwise people would stop investing altogether. We keep them in stocks for the long-term portion of their account and then we compromise. We take their new money and put it in a short-term account where it won't lose anything."

Investors are learning to pay more attention to fees during this time of super-low yields. But experts point out that fees are just as important when yields are 6 percent as when they're below 1 percent. Fees, taxes, and inflation eat away at your total return; fees are the one element you have some control over.