What does this mean for your money market investment?
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By Karen Dolan, CFA | 09-17-08 | 02:30 PM | Email Article

Money market funds are considered a safe place to park your cash and with rare and infrequent exceptions, they have lived up to that promise. However, they are not guaranteed or backed by the FDIC, so the risk of losing some capital in a money market fund is there.

Karen Dolan is director of fund analysis with Morningstar.

That risk hit him home yesterday when one of the country's oldest and largest money market funds, The Reserve Primary Money Market Fund, broke the buck. Rather than keeping its net asset value stable, at $1.00, its NAV dropped to $0.97. That, in turn, immediately put that fund's future on shaky ground--and money market investors on high alert.

Here are answers to some of the key questions surrounding this event.

What Happened at The Reserve Primary Money Market Fund?
Two things contributed to the events at Reserve Primary Money Market Fund. For one, it owned Lehman Brothers bonds, which the firm deemed to be worthless on Tuesday. Second, a large number of investors appeared to be aware of the problems and yanked a reported $40 billion (well more than half of its asset base) out. Because the managers had to sell securities into an inhospitable market, the redemptions exacerbated the losses for those investors who remained in the fund, and turned what might've been a 1% loss into a 3% loss. The fund is now on lockdown and has frozen redemptions for seven days in an attempt to stop the bank run and try to restore some order. For investors in this fund, the good news is that the losses are likely to be contained. Even so, the breakdown means that it is not an investment worth sticking with.

Are Other Money Market Funds at Risk?
If there's one thing that gives us confidence that this event will be contained rather than widespread, it is that the stakes are much higher for asset management firms than for investors. Asset managers would suffer a huge reputational blow if they were to "break the buck," and we think that will serve as an important backstop here. While The Reserve clearly did not have the financial wherewithal to swoop in and make investors whole by injecting its own money to keep the fund's net asset value stable at $1.00, we think it's highly likely that other asset management firms that have the financial ability would do so if faced with the same predicament. In fact, a number of firms have quietly done so over the past year.

A failed money market operation can exact a steep toll on a firm's brand and future business. Investors stand to lose pennies on the dollar, but asset management companies that are in the money market business stand to lose everything. For that reason, we'd be surprised to see this problem spread to too many other money market funds, and we would be shocked to see it extend to funds run by larger more diversified institutions. (The Reserve was only in the business of money markets and thus didn't have other business lines or enough cash it could tap.)

How Can I Tell If My Money Market Fund Is at Risk?
It's important to keep two considerations in mind as you consider if your money market fund is in danger. First, which firm is backing it? If you're invested with a large fund company such as Fidelity or Vanguard, it's probably safe to say that you are in good hands. Both of those firms have openly communicated with their investors amidst this ordeal and have given no signal that they are in danger of breaking the buck.

Vanguard reports its funds didn't own any Lehman paper, and it is instead heavily invested in U.S. Treasuries, Agency bonds, and certificates of deposit, all of which carry a government guarantee. That profile fits Vanguard's value proposition to a T; it competes by being the low-cost provider and therefore has no need to reach for extra yield by taking undue risks.

Fidelity also released some information on its homepage assuring money market fund shareholders that maintaining a $1.00 NAV is a top priority. Fidelity is a huge company with a lot of cash at its disposal, so we're confident it would stick to this promise even if it means that the firm would have to step in with its own cash to keep the NAV stable. As part of its Web site update, Fidelity also provided up-to-date information on the funds' holdings in Lehman, AIG, and Merrill Lynch, none of which seem large enough to raise any red flags. Other fund firms are putting information out on their Web sites regarding their money market funds, so it is worth checking into what the firm backing your money market fund is saying.

The second consideration is whether or not the fund you own pays a yield that seems to be too good to be true. Morningstar has data on just over 2,100 money market funds, and the Reserve Primary Fund clocked in at an average trailing 12-month yield of 4.04%--the highest in our universe--while the average was 2.75%. Although there are rules in place intended to prevent money market funds from taking undue risk, there is still no free lunch, and funds that pay out higher yields (unless the yield advantage is a sole function of their lower expense ratios) are likely to be stretching further out on the risk spectrum than are funds with more modest yields.

In all, your best bet is to stick with low-cost money market funds that don't need to stretch for yield from large reputable shops that have the resources to fulfill their promise.

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Karen Dolan, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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