By Gary Arne
Money-market funds, long considered among the safest and most stable of investments, are the overwhelming choice of risk-averse mutual-fund investors. In today's volatile investment climate, investors have increasingly turned to these funds, putting some $2.15 trillion into U.S. money-market funds as of October 31, 2002. They've remained popular even though the
yield on the average U.S. money-market fund recently hovered near an all-time low of 1%.
The low yields are vexing enough for fixed-income investors -- although they still look pretty good compared to the losses posted by the average equity fund over the past few years. But they may also be the cause of another unpleasant surprise. Since fund expense ratios -- the percentage amount a fund charges to cover operating costs -- may in some cases exceed the actual yield, investors who redeem their fund shares may find that their balance is actually lower than the amount they originally put in. In essence, the fund has posted a negative return, even though it has maintained its principal value and had a positive yield.
If short-term rates remain where they are now, this could become more widespread, as higher-yielding assets held by funds roll off or mature, and are replaced by assets with lower yields. Right now, many money funds -- especially institutional ones -- are partially waiving or cutting fees to avoid this situation and to remain competitive. And retail funds (those sold to individual investors) may adopt similar measures as well -- especially if they start to experience large outflows.
Some fund professionals have warned that if rates go even lower, it might cause money-market funds to "break the buck" -- a situation where the fund's principal value dips below $1 per share. But it's important to realize the difference between high management fees eating up a fund's principal and the erosion in a fund's assets because of portfolio investment losses.
We at Standard & Poor's have been assigning safety and stability ratings to money-market funds since the mid-1980s. We thought we'd try to answer some questions investors might have about fund ratings -- and why a money fund's negative return may have nothing to do with the soundness of its investment portfolio.
Q: What exactly does a money-market fund rating from Standard & Poor's mean?
A: S&P's money-market fund rating addresses the safety of the fund's investments, and therefore, focuses on a fund's ability to limit loss. The fund ratings use the same letter scale as S&P's credit ratings, but with an "m" affixed to indicate a money-fund rating. Thus, AAAm would denote an issue with the highest safety rating, AAm the next highest, and so on.
In the U.S., money funds seek to maintain a stable net-asset value -- or a $1 net asset value per share. The safer money funds seek to avoid "breaking the buck" by investing in highly creditworthy, short-term, and very liquid investments -- while avoiding securities with higher degrees of credit, market, or liquidity risk.
Q: With money-fund yields now averaging between 0.75% and 1.25%, how does S&P factor into account the management fees and expenses of the fund when it assigns its ratings?
A: While investors should be mindful of the fee structure of a money market fund -- particularly its total expense ratio -- fees are not part of S&P's ratings assessment. The rating is focused on a money fund's ability to avoid losing 1/2 of 1% or more (because if it loses more than half a penny, it would be forced to pay out 99 cents a share -- thus "breaking the buck"). So the primary focus of S&P's analysis is the fund's portfolio level risk -- mainly credit and market risk, liquidity, and management.
Therefore, as long as the fund's market value doesn't deviate by 1/2% and it has sufficient liquidity to meet redemptions, the fund should maintain a stable share price. Yields have and will continue to rise and fall over time. Right now, yields are at their lowest level since the 1960s.
Q: If an individual invests $10,000 in a rated money fund and receives back $9,950 at the end of one year, doesn't this mean that the fund lost money -- or does it mean that the fund "broke the buck"?
A: While the investor may not be happy with the return of the investment, the fund has maintained principal value and did have a positive yield. In this situation, it's likely that the fund's fees were higher than its yield -- canceling the yield that the fund earned.
Let's say the fund had a 1% yield over the past year, but its total expense ratio was 1.5%. In this situation, the investor would receive back his original $10,000 investment, plus the 1% yield -- minus the 1.5% charged by the fund company -- thereby netting the investor an amount lower than the original $10,000 (approximately $9,950). If the fund had a total expense ratio of 0.5%, it would have generated a positive return of nearly $50, and the investor would have received back $10,050 at yearend (for a return of 0.5%).
Q: So exactly when does a fund "break the buck"?
A: The best way to explain this is with another example. Let's say you invested $10,000 one year ago in a money fund yielding 4%, with a total expense ratio of 1.5%. Unfortunately, the fund experiences a problem with one of the securities in its portfolio, and realizes a loss on the investment equal to 2% of the fund's portfolio. That loss is reflected in the amount of assets available to pay investors when they decide to redeem their shares in the fund.
Here's the unpleasant part: If you decide to redeem your shares at this point, they're now worth 98 cents. While you may receive a check in the net amount of $10,050 -- your principal (now $9,800), plus the $400 dividend payout, minus $150 in fund expenses -- this fund actually experienced a principal loss since its market value deviated by more than 1/2 of 1% (2%, in this case). This is when a fund "breaks the buck." So even though the fund had a higher return for the one-year holding period, it did lose principal value. It should be emphasized, though, that this is an exceptionally rare occurrence.
Q: With current yields so low, is S&P concerned that money funds might take on more risk to push up their yields?
A: Bond-fund-like investments are now being offered to managers of money-market funds. This is similar to what the market saw back in 1994, when more than 30 fund advisers took on additional risk -- and ultimately paid for it by having to inject money into their funds after the higher-risk instruments sustained losses. While these types of securities may have high credit ratings, they all possess an increased degree of market risk in the form of lower liquidity or event risk.
Q: How can a money-fund investor get information on S&P's rated funds?
A: The best place to get information is on our Web site -- www.standardandpoors.com -- and look for the links to money funds and bond funds on the left side of the home page.
At this site, you can find our global-ratings list of money-market funds -- and also search for funds. There's also a full description of the money funds ratings criteria, as well as write-ups on rated funds.
Q: Finally, what can money-fund investors do in this environment?
A: Obviously, at this point, fees are important -- the higher the fee, the more a fund has to earn to maintain a positive yield. As for risk, it's not easy for an individual investor to ascertain from the information available from typical sources. That's why fund ratings can be a good place to start your research. Arne is managing director of fund research for Standard & Poor's