Less Than Zero

You probably woke up this morning worried about your finances. But like many Americans, you may be feeling a bit better today than you did this time last year for two significant reasons: 1) a record, somewhat unexplainable, run-up in the stock market in 2009; and 2) some of your assets are now sitting in a plain-old money market fund.

It probably doesn’t make much sense to try to unravel the mysteries behind the rise in the stock market, but deciphering your good feelings about your money market fund is easy. After all, unlike most other investments, money market funds (with two notable exceptions) didn’t lose any money in 2008 or the first quarter of 2009. Sure, they’re not paying much interest at the moment, but not losing can sometimes feel a lot like winning.

Your money market fund is currently valued at $1 per share. Assuming that it’s been around a while, this is the exact same amount it was worth last week, last year, and the last time you had to ask your parents for permission to stay out past 10:30.

The interest the fund pays, however, is not quite the same constant companion. While it may have paid in the range of 4 – 5% a few years back, a quick check of your current statement will likely show that it’s currently paying a fraction – a tiny fraction – of 1% on an annual basis. This less-than-compelling rate is a by-product of our extremely low rates in the short-term portion of the yield curve.

There is nothing inherently wrong with the rate of interest currently generated by your fund. Many investors are glad to sacrifice a potential upside for the relative certainty that there isn’t a downside. What you might have missed, though, is that money market funds – like all mutual funds — have expenses that are required to maintain their operation. Some portion of these expenses goes to the administration and management of the fund. The remainder represents profit for the firm charged with selling and managing the fund. These expenses are taken as a daily factor against the net asset value (that $1 per share) of the fund. The general idea, in normal times, is that the interest earned by the fund will far offset the expenses.

As it turns out, we are not in normal times.

If the ABC Money Market Fund earns 4% in interest in given year and has an operating expense of .50%, then the shareholder receives a net return of 3.5%. What happens when ABC Money Market Fund only earns .25% in interest over the course of a year?

The management of ABC Money Market Fund has few options. They can’t change their stripes and begin investing in longer-term or higher risk investments or they will no longer qualify as a money market fund. They also can’t assess their full fee of .50% or they will “break-the-buck” by causing the fund to fall below its $1 net asset value.

Ultimately there is one practical solution: the management of the fund can volunteer to waive a portion of its fee (.25% in this case) to keep the fund from falling below its $1 net asset value. This is not an insignificant gesture as the profit margins in this investment category can be skinny and the management does have costs to cover. Further, these are lean times in the financial industry, and giving up profits or incurring debt on what was supposed to be a money making proposition is not an easy decision – particularly for publicly-traded investment houses that are trying to keep the value of their own stock price above water.

Many money market managers are wrestling with this exact decision right now. A typical explanation of this process is found in this excerpt from the prospectus of an actual money market fund:

The expenses shown in the fee table in Section 1 are generally based on a fund’s prior fiscal year-end (May 31). In periods of market volatility, assets may decline significantly, causing total annual fund operating expenses to become higher than the numbers shown in the fee table.

To the extent necessary to maintain a net yield of 0.00% on any day that a dividend is declared, T. Rowe Price may voluntarily waive all or a portion of the management fee it is entitled to receive from the fund for that day. T. Rowe Price may amend or terminate this voluntary waiver of its management fee at any time without prior notice.

– For a complete copy of the above referenced prospectus please click the following link to the T. Rowe Price Prime Reserve Fund including the excerpt that can be found on page 22 of the document.

This manager has left itself the room it needs to navigate the issue and will cross that proverbial bridge when required to do so.

Other managers are taking a different tack:

*** In addition to the contractual expense limitation discussed above, Schwab and the investment adviser also may voluntarily waive and/or reimburse expenses in excess of their current fee waiver and reimbursement commitment to the extent necessary to maintain the Investor Shares’ net yield at a certain level as determined by Schwab and the investment adviser. Under an agreement with the fund, Schwab and the investment adviser may recapture from the assets of the Investor Shares any of these expenses or fees they have waived and/or reimbursed until the third anniversary of the end of the fiscal year in which such waiver and/or reimbursement occurs, subject to certain limitations. These reimbursement payments by the fund to Schwab and/or the investment adviser are considered “non-routine expenses” and are not subject to any net operating expense limitations in effect for the Investor Shares at the time of such payment. This recapture could negatively affect the Investor Shares’ future yield.

– For a complete copy of the above referenced prospectus please click the following link to the Schwab Value Advantage Money Market Fund including the excerpt that can be found on page 4 of the document.

In English, the language purportedly used in the prospectus, this manager is temporarily waiving fees to maintain a $1 net asset value but is also reserving the right to recoup these waived fees at a future date. In this case, it’s not really a waiver but a deferral of fees and, as stated in the last sentence of the footnote, applying these additional deferred fees on the fund could well have the affect of keeping the interest paid to investors down for a lengthy period.

Investors that focus solely on the preservation of capital aspect will likely not be troubled by this type of revelation. Those who are interested in the idea of growth–any growth– of their assets in the near-to-mid term should probably take the time to contact their money market manager to see what is in store for their particular fund in terms of fees and interest.

Finally, I should point out that investors within 401(k) plans that feature asset-based charges will almost certainly have negative returns on any money market investment they hold. These asset-based fees are charged by the recordkeepers or outside investment advisors linked to the plan, and neither group is likely to waive – or even defer – its fee. Asset-based fees can occur in any type of plan but are prevalent in group annuity contracts sold by insurance companies (look for the words “group annuity” anywhere on your statement or your plan’s website).

Investors who are looking for meaningful amounts of interest in the near-to-mid term may have to sacrifice the safety of their money market option for a short-term bond fund or other options further out on the risk/reward continuum. Let’s be careful out there.

*Originally published November, 2009.

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