By Terry Coxon
The Casey Report

Money market funds began as a bright and useful idea, became a habit, and recently have become a bad habit.

Money market funds were invented in 1971 as an innovative end-run around Federal Reserve Regulation Q, which prohibited paying interest on demand deposits. The purpose of Reg Q was to stifle competition in the deposit-taking business in order to benefit commercial banks – at the expense, of course, of depositors.

The regulation had little effect until the late 1960s, when two factors converged. The first was consumer price inflation; it was mild compared to what was soon to follow, but it was still noticeable, and it fueled a general rise in interest rates. The second factor was the arrival of the IBM 360, which made computing much cheaper. Before that device, the administration of checking accounts was still labor intensive and little advanced from the days of green eye-shades. It was expensive for banks to maintain checking accounts, so they weren't inclined to pay interest on them, Reg Q or no Reg Q.

Then the drop in the cost of maintaining checking accounts and a rise in the revenue that could be earned from investing depositors' money turned demand deposits into a very attractive proposition for banks. Since Reg Q forbade head-on competition for deposits, individual banks did what cartel members always do when there are profits to be made – look for ways to compete indirectly. In lieu of paying interest, banks began giving away premiums to attract large deposits. The era of the free bank toaster was born.

The first money market fund, Reserve Fund, went far beyond small appliances to exploit the opportunity provided by high interest rates and cheap data processing. The legal strategy devised by the fund's promoters was to avoid the regulatory environment of banking with its Reg handcuffs and instead to set up shop as a SEC-registered mutual fund. But unlike any mutual fund up until then, it didn't invest in stocks and bonds; it invested in jumbo bank CDs earning open-market yields. And its share price didn't fluctuate; it was held steady at $1.00 by paying a tiny dividend every day, which could be reinvested automatically in more shares. Shareholders could redeem by writing a check, which the fund would cover when it was presented to the bank where the fund kept its checking account.

From an investor's point of view, Reserve Fund was functionally a bank, even though legally it was an investment company. But for all intents and purposes, it was a bank with zero net capital, which meant that its investment policy had to be emphatically conservative. So, since the jumbo CDs that the Reserve Fund was buying were far bigger than FDIC insurance limits, the fund bought only from banks it considered indestructible. Shortly after Reserve Fund opened for business, another invention, Capital Preservation Fund, took conservatism to an extreme with a policy of investing only in Treasury bills. This made the fund's shares arguably as safe or safer than FDIC-insured deposits, and with no limitation on size (the FDIC insurance limit at the time was $10,000).

Good as the idea was, money market funds got off to a slow start with the public, but the continued upward trend in inflation and in interest rates soon turned them into a giant industry with hundreds of funds and a river of management fees flowing to their promoters. And for the most safety-minded investors, the Treasuries-only funds offered a welcome refuge from worries about the reliability of commercial banks.

Money market funds are still a giant industry, but you have to ask why. Limits on bank deposit interest rates are long gone for individuals, so even before today's near-zero returns, the yield advantage on money market funds was modest at best. And with the bogeyman of sovereign default peeking out of so many windows lately, the phrase "Treasury bills-only" no longer has quite the tranquilizing effect it once did. In fact, given that most FDIC-insured deposits are owned by Americans (aka potential voters) while much of the Treasury debt is owned by non-voting foreigners, FDIC-insured bank deposits may be a better bet than T-bills.

Take a look at what is now the largest retail money market fund – Fidelity Cash Reserves. It has $120 billion in assets. The yield for investors is 0.01% – keep a hundred dollars in the fund for a year and you get a penny. Put $10,000 into the fund and twelve months later you have $10,001. And there are risks: the fund holds nearly 52% of its assets in uninsured bank CDs and another 14% in commercial paper. I can only surmise that most of the $120 billion is there because of investor habit and inertia.

Money Market Funds: An Idea Whose Time Has Passed

Today there is little good reason to use a money market fund for substantial amounts of cash.

1. There is no material yield advantage because there is no material yield on cash anywhere – unless you are willing to take risks that mock the idea of cash. The highest yield on a money market fund I've seen since the Federal Reserve hammered rates into the floor at the end of 2008 was an offshore operation called Bank of Ireland USD Liquidity Fund, with a yield of 0.54%. How the fund earned that much (after expenses) in a world where 30-day jumbo CDs return 0.20% and one-month T-bills yield 0.04%, I don't know. But if the fund's risk disclosure was adequate, it would have included language that amounted to "Baby needs shoes!"

2. With most money market funds, there is a material safety disadvantage vs. FDIC-insured CDs since, of course, commercial paper and jumbo CDs carry a risk of default.

3. With a T-bill-only fund, the best you can say in favor of the fund vs. FDIC-insured CDs is that it's a tossup. Both are very secure.

If you invest with a family of mutual funds, moving redemption proceeds into a money market fund in the same family is convenient. But I recommend enjoying that convenience only if the fund really is limited to Treasury bills. And you'll have to read the fund's prospectus to be confident that that is the case. Don't rely on the fund's name to tell you where your money is. A "government-only" fund typically invests in IOUs from US government agencies or government-sponsored enterprises or in private loans secured by such IOUs. Even if the fund has "Treasury" in its name, you may find upon close examination that T-bills are the primary investment but that the fund puts 15% or 20% of its assets into uninsured CDs to spice things up. So if you consider the homework needed to be sure you're getting T-bills and nothing but T-bills, the convenience argument for using the fund gets weak.

The reason for holding part of your wealth in cash is absolute protection from default risk. If a money market fund doesn't provide that protection, it isn't really a cash medium. It's something else.

Even though they may not know it, few mainstream investors have actually made money in recent years, due to inflation eating away at the meager gains these investments provide. Try crisis investing like the pros: subscribe to The Casey Report today… and save an incredible 72% off the list price. But hurry, this offer ends at midnight, November 4.

The Casey Research web site & Kitco Casey web site, Casey’s Investment Alert, Casey's International Speculator, Casey's Gold & Resource Report, Casey’s Energy Confidential, Casey's Energy Report, Casey’s Energy Opportunities, Casey's Trend Trader, The Casey Report, Casey's Extraordinary Technology, Conversations With Casey, and Casey's Daily Dispatch are published by Casey Research, LLC. Information contained in such publications is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The information contained in such publications is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. The opinions expressed in such publications are those of the publisher and are subject to change without notice. The information in such publications may become outdated and there is no obligation to update any such information.

Doug Casey, Casey Research, LLC, Casey Early Opportunity Resource Fund, LLC and other entities in which he has an interest, employees, officers, family, and associates may from time to time have positions in the securities or commodities covered in these publications or web site. Corporate policies are in effect that attempt to avoid potential conflicts of interest and resolve conflicts of interest that do arise in a timely fashion.

Any Casey publication or web site and its content and images, as well as all copyright, trademark and other rights therein, are owned by Casey Research, LLC. No portion of any Casey publication or web site may be extracted or reproduced without permission of Casey Research, LLC. Nothing contained herein shall be construed as conferring any license or right under any copyright, trademark or other right of Casey Research, LLC. Unauthorized use, reproduction or rebroadcast of any content of any Casey publication or web site, including communicating investment recommendations in such publication or web site to non-subscribers in any manner, is prohibited and shall be considered an infringement and/or misappropriation of the proprietary rights of Casey Research, LLC.

Casey Research, LLC reserves the right to cancel any subscription at any time, and if it does so it will promptly refund to the subscriber the amount of the subscription payment previously received relating to the remaining subscription period. Cancellation of a subscription may result from any unauthorized use or reproduction or rebroadcast of any Casey publication or website, any infringement or misappropriation of Casey Research, LLC's proprietary rights, or any other reason determined in the sole discretion of Casey Research, LLC. © 1998-2010 by Casey Research, LLC.