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Is A Portion Of Your Portfolio ‘In Cash’?

46876406 - money tree. Most people who have any kind of investment account have some portion of their portfolio sitting in a money market fund. That piece is often referred to as being “in cash.” But even though many people are invested (at least in part) in money market funds, we find that very few people actually know what a money market fund is. In our practice, Jeff and I do our best to educate our clients about all aspects of their financial life. Since money market funds comprise a piece of most portfolios, I thought it would be a good time to talk to you, Cutter Family Finance readers, about the different kinds of money market funds and some upcoming changes to the rules pertaining to them.
 
But first let me explain the difference between a money market account and a money market fund. A money market account, held at a chartered financial institution, is usually invested in short-term, fixed income securities. It can earn a higher interest rate than a savings account at the same institution. In exchange, typically, a money market account must maintain a minimum balance. Such accounts are FDIC insured. A money market fund, on the other hand, is a mutual fund. Money market funds also invest in short-term, fixed income securities. However, they are not FDIC insured. Money market funds and money market accounts typically provide what many people consider the equivalent of a savings account, but with higher returns than interest-bearing bank accounts.
 
Generally, there are three different kinds of money market funds: prime funds, municipal funds and government funds. A prime money market fund invests in corporate securities with a duration of less than one year. Municipal funds, as the name implies, invest in tax-exempt municipal securities and government funds invest in United States government securities.
 
For many years, all money market funds maintained a stable $1 Net Asset Value (NAV), despite market movement in their underlying securities. But in 2008, during the financial crisis, the well-known Reserve Primary Fund “broke the buck.” Its NAV dropped below $1, to 97 cents per share, due to losses on holdings in Lehman Brothers, when Lehman Brothers filed for bankruptcy. This triggered a rush of redemption requests, which led to a redemption freeze for seven days, followed by a liquidation of the fund.
 
As a result, back in 2010, some of the rules pertaining to money market funds were changed. According to the SEC, the amendments to those rules were “designed to make money market funds more resilient by reducing the interest rate, credit and liquidity risks of their portfolios.” But more recent reforms that take effect this October will result in even more changes to the rules related to money market funds. In order to understand the upcoming changes, let me first remind you of the differences between retail investors and institutional investors (a topic we have touched on in past articles).
 
A retail investor is an individual who invests for his or her own personal benefit. An institutional investor, as you can guess, is an institution, such as a pension fund, insurance company or charitable foundation, that typically invests for the benefit of others.
 
The new rules pertaining to money market funds are applied differently depending upon the type of investor buying the shares. Prime money market funds and municipal money market funds that are available only to institutional investors, going forward, must allow their NAV to fluctuate in order to reflect the current market value of the securities held by the fund.
 
On the other hand, all government funds (available to both institutional investors and retail investors) and prime money market funds and municipal money market funds, available to retail investors, are permitted to try to keep their NAV stable at $1. However, there are additional restrictions available to all prime and municipal funds. For example, all non-government money market funds will have the option of imposing a 2% redemption fee if a fund’s weekly liquid assets drop below 30% of its total assets. Those same non-government money market funds will be required to charge a 1% redemption fee when weekly liquid assets drop below 10% of total fund assets, and under certain circumstances, non-government money market funds will also be able to suspend redemptions.
 
The new rules may seem confusing, but the important thing to focus on is how these new rules will affect investors.
 
The biggest change is what I’ve already touched on. As the market moves, and credit conditions and interest rates change as well, the share price on non-government institutional funds could fluctuate above or below that one dollar mark. All retail money market funds and institutional government money market funds, on the other hand, will likely maintain, (or at least attempt to maintain) the $1 share price in the future. It’s important to note, however, that any fluctuation from the $1 NAV in those institutional non-government funds is expected to be incredibly small, potentially just a fraction of a cent higher or lower.
 
The second biggest effect of the new rules is the imposition of those redemption fees and sales restrictions in times of market stress. As explained above, any non-government money market funds will be allowed to charge up to a 2% fee on redemptions, or even disallow redemptions if a fund’s liquid assets fall below 30% of total assets in that week. Either move must be considered “in the share-holders’ best interest” for a company to impose this restriction. Additionally, these funds are only allowed to suspend redemptions for a maximum of 10 business days in a single 90-day period.
 
One other result from the amendments to these rules is that now, it is the responsibility of the fund companies to rate their own holdings and analyze the credit risk associated with any potential securities they invest in. As of 2015, funds are no longer required to invest only in securities that qualify for the top two credit rating categories of short-term debt. The board of a money market fund, or its delegate, must instead determine which securities present the lowest credit risks, and the new rules impose guidelines on how to make that determination.
 
As with any financial decision, the devil is in the details, and before you put a portion of your portfolio “in cash,” it is important for you to understand what that means.
 
As Jeff always says, be vigilant and stay alert, because you deserve more!