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The Honolulu Advertiser

Posted on: Sunday, June 22, 2003

Money fund yields keep slipping

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By Todd Mason
Knight Ridder News Service

"More money has been lost reaching for yield in the bond market than has ever been lost on stocks."

—William J. Bernstein,
Investment author
Forget about the bear market on Wall Street, investment author William J. Bernstein says. Marvel instead at ridiculously low returns on money-market mutual funds.

"This is the big story in investing," said Bernstein, author of the book "Intelligent Asset Allocator," and otherwise a neurologist in Oregon.

"Money funds are a horrible deal. The risk-free return is gone."

Some story. At last week's average annual yield of 0.68 percent, investors lost ground on taxable money funds, after subtracting inflation at 2 percent a year, and picked up a tax bill for their troubles.

And investors wouldn't be doing that well if fund managers weren't eating expenses. In iMoneyNet's surveys, the expenses of running the average money fund in April, at 0.78 percent, consumed all of the average yield (0.56 percent), and then some.

Money-market mutual funds are expensive to run because they function like checking accounts — temporary homes for a cash reserve or for investment money between assignments. Money funds invest in short-term government and corporate securities that split the difference between yield and safety.

Yields are likely to slip more as the Federal Reserve Board meets this week to decide the future of interest rates.

If the Fed trims the federal funds rate from 1.25 percent to 1 percent, as expected by Wall Street, money-market yields will drop in line.

Bernstein's advice to money-fund investors is to grin and bear it. He cautions people who might be tempted by riskier investments: "More money has been lost reaching for yield in the bond market than has ever been lost on stocks."

Or consider safe alternatives such as opening a money-market account at a top-paying bank, or buying Series I savings bonds, which bear interest adjusted to keep pace with the consumer price index. The earnings for a Series I bond bought through October is 4.66 percent, but there is a three-month earnings penalty if an investor cashes in before five years.

Money-fund investors might also consider moving to the tax-free variety, which often outearn the taxable kind these days, before taxes as well as after.

For example, Vanguard's Pennsylvania and New Jersey tax-free funds each earned 0.93 percent last week vs. 0.91 percent for Vanguard Prime, the taxable alternative, according to iMoneyNet.

Low-cost money-fund managers such as Vanguard, of Malvern, Pa., and SEI Investments Co., of Oaks, Pa., stand to benefit if the drought drags on. So will the banks paying aggressive yields on money market accounts.

Math is destiny, John Hollyer, a senior fund manager at Vanguard, explains.

"The yield in the marketplace is the yield in the marketplace," he said. "Subtract expenses from that, and investors get what's left."

With the average expense ratios for retail funds higher than average yields, what's left is a major headache for the mutual fund industry.

At SEI, "we've instituted a client floor" of 0.15 percent, senior vice president Lori Heinel said. "If the net (yield) drops below that, we'd start to waive fees to hold it at that level." Last week, none of SEI's money funds yielded below 0.85 percent.

"Until now, funds have been waiving fees to keep a floor under their yields," said Peter Crane, managing editor of iMoneyNet's Money Fund Report.

"Nobody has done it yet, but people are talking about more permanent solutions."

The key question is how quickly the economy will bounce back, said Bradley Sweeney, a senior fund manager at Morningstar Inc., the Chicago mutual fund research firm.

"A lot of the managers we are speaking to expect this low-interest-rate environment to persist for some time," Sweeney said.

For fund families, the ultimate solution is asking investors to take their money back. Most would do so reluctantly because the trend is to add funds to offer a more comprehensive investment answer to investors.

Another solution is to allow rates to go negative, in effect, to claim some of their investors' principal to cover expenses not paid by investment earnings.

Because of their low costs, SEI and Vanguard bear up well under either scenario, Crane said.

The rest of the money-fund industry "is going to be a blazing pile of ruins" before Vanguard eats any of its expenses, he said.

He said the good news for the industry was that investors don't seem to be in any hurry to reclaim their money, which amounts to $2.2 trillion.