How This Year’s Hottest Investment Could End Up Costing You

How This Year’s Hottest Investment Could End Up Costing You
How This Year’s Hottest Investment Could End Up Costing You

Summary

Money-market funds are seeing record interest, but advisers say cash is no substitute for stocks and bonds

Cash has rarely been this hot on Wall Street. Financial advisers warn holding too much can burn a hole in your portfolio.

With markets rocky and cash earning 5% or more, investors have boosted their holdings of money-market funds to a near-record $5.6 trillion, according to the Investment Company Institute. Both individuals and institutional investors are piling in—asset managers now have roughly one-fifth of their portfolios in money-market funds, State Street data show.

Cash was trash for years on Wall Street, where low interest rates left investors buying every dip, saying there was no alternative to stocks. The prospect of a prolonged period of higher rates has upended that thinking, buffeting both stocks and bonds while increasing the returns offered by some of the safest, shortest-term investments such as money markets.

Yet many advisers caution that fees, taxes and inflation all undermine those returns. And one of the biggest costs is opportunity: By pouring money into cash, investors miss out on potential gains from holding a broad portfolio of stocks, bonds and other riskier investments.

“Money-market funds are a rational place to be for the next six months. But over the long term, taking risks pays you more," said Wylie Tollette, chief investment officer for Franklin Templeton Investment Solutions. “Keeping any more than a small allocation to cash in your portfolio, for any longer than the short-term, will ultimately cost you thousands or millions of dollars."

Though often treated as akin to a bank account, the funds differ from normal savings accounts and other cash-like investments, such as CDs. They typically lend cash to banks overnight (backed by Treasurys), park it at the Fed or invest in Treasury bills maturing in a few months. Still, they are considered equivalent to cash because investors generally expect to get their money back whenever they ask. To that end, the funds try to maintain a net asset value of $1 a share.

Yields fluctuate with benchmark rates set by the Federal Reserve. Right now, the $265 billion Vanguard Federal Money Market Fund yields 5.3%, earnings that are distributed via dividends. The popular Fidelity Government Money Market Fund yields 4.99%, though requires no minimum amount to invest in the fund. Vanguard asks for at least $3,000.

Though considered to be among the safest of all investments, deposits in the funds aren’t insured and they have occasionally gone haywire in times of stress. Shares of one fund fell below $1 a piece when Lehman Brothers failed in 2008, prompting a federal backstop. Regulators also stepped in to backstop the funds during the market turmoil of the pandemic’s early days. That episode prompted a rewriting of the rules guiding money-market funds for the third time in 15 years.

Those considerations haven’t driven away investors. The Fed’s most aggressive interest-rate campaign in decades has lifted rates near the returns many investors would expect from their portfolio on an average year. With the central bank expected to hold rates near this level for some time, money-market funds are now considered a viable investment rather than just a place to stuff cash. The influx into money markets also accelerated this year after the failure of Silicon Valley Bank left depositors worried about how protected their money was in banks.

“The fed-funds rate is likely to be between 3% to 4% for the long run, stock valuations are lofty and bond volatility doesn’t look like it’s abating anytime soon," said John Tobin, chief investment officer for Dreyfus, one of the world’s largest money-market fund managers. “If we are delivering 4% returns in a world of two-and-change percent inflation, I think cash becomes a real asset class and we hold on to a lot of the assets under management we’ve accumulated."

But advisers warn that investors should carefully consider how much of their portfolio to park in cash. Since its 1981 inception, the Vanguard fund has returned an average of 3.9% a year, or a cumulative 402% through the end of September. The S&P 500 has returned nearly 11% a year and about 3,500% through the same period. The Bloomberg U.S. Aggregate bond index returned 6.8% annually, or 1,500% in total.

The S&P 500 is still up 8.5% this year despite rising rates. Meanwhile, the benchmark bond index has lost 2.5% as longer-term bond prices have fallen due to climbing yields.

Fees are also relatively high. Investors pay annual expenses based on how much they have invested in a fund. Many large money-market funds charge 0.5% a year in fees, if not more, to support upkeep including administration, trading costs and employee salaries. Some stock funds, such as the SPDR S&P 500 ETF, charge less than one-tenth of a percentage point annually.

Those fees drag on returns over time. Investing $10,000 into a BNY Mellon fund at the 0.33% rate charged to wealth-management clients would cost $418 in fees over a 10-year period. The same amount at the outside investors’ rate of 0.58% would cost $726.

“There’s a psychological component to seeing 5.5% in a money-market fund after stocks and bonds got slapped in the face over the past couple years," said Alex McGrath, chief investment officer for Greenville, S.C.-based NorthEnd Private Wealth. “But if you take all your chips off the table, that’ll hurt you when the market recovers."

Taxes are another consideration, and often a big one. Interest payments on money-market funds are generally taxed as ordinary income, not at dividend or capital-gain rates. How the income is taxed at the federal or state level will depend on the investments a fund holds. Interest from U.S. Treasury debt, for example, is taxable at the federal level, but not for states. However, many government money-market funds now hold repurchase agreements, which are generally taxable at the state level. In other words, it’s complicated; taxes can lower headline yields for those who aren’t careful.

Even after fees and taxes, money-market investors suffer another drag: inflation.

If a fund yields 5%, but the consumer-price index is rising at 3.5%, then an investor’s cash is only growing at 1.5% a year in real terms. Should inflation rise above prevailing interest rates—which happened last year when the CPI reached 9% and the federal-funds rate was below 1%—investors are effectively losing money.

Simon Hamilton, managing director at the Wise Investor Group of Raymond James, said he tells clients that having a large cash position is a bet on rates going higher down the road. That might happen, but they should be considering locking in some of bonds’ relatively high yields today.

“There’s an old expression: you date cash, you don’t marry it," he said.

Write to Eric Wallerstein at eric.wallerstein@wsj.com

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