Making sense of money market funds
April 01, 2013
Replay and transcript from a recent Vanguard webcast
Money market funds are a vital cash management tool for many investors. In this live webcast, aired Thursday, March 7, 2013, David Glocke, who oversees Vanguard's money market fund investments, and Sarah Hammer, a senior investment analyst with Vanguard Investment Counseling & Research, discussed the current environment for money market funds and how investors could use them as part of their diversified investment portfolios.
Amy Chain: Good afternoon and thanks for joining us for this live Vanguard webcast, whether you're viewing us through your computer, your tablet, or even your smartphone. I'm Amy Chain and today we're talking about money market funds, an investment that the Investment Company Institute recently noted had more than 29 million accounts. That's a lot of accounts and a lot of people using them.
We have two experts joining us today. David Glocke, who heads the taxable money markets and Treasury bond trading groups here at Vanguard, and also Sarah Hammer, a senior analyst in Vanguard's Investment Counseling & Research Group.
David and Sarah, thanks for being here today.
Sarah Hammer: Thanks, Amy.
David Glocke: Thanks.
Amy Chain: Money market funds have been in the news quite a bit recently. Regulators are considering several proposals that could change how money market funds operate. Since the FDIC stopped its unlimited guarantee of zero-interest checking accounts, some investors are thinking differently about money market funds.
We'll start today by chatting with David and Sarah about money market funds and how you should be thinking about them as an investor. But as always, today is about you and your questions. We've got lots pouring in already. So we'll spend most of the time talking about those questions, getting some answers from our experts.
But we're going to start with a polling question for you, audience. If you have a question today, though, I want you to know that you can send it to us through Twitter using #VGLive. Does that sound good everybody?
Sarah Hammer: That sounds great.
David Glocke: Yes.
Amy Chain: All right. So, audience, first question is coming to you. It should be popping up on the right-hand side of your screen right now, and that question is: "How do you use a money market fund?" Your options are: "cash management," "short-term goals," or "income," or simply "other," if you have another idea for us. So go ahead and weigh in, and while we're waiting for our audience to weigh in, Sarah, I'm going to come to you with a question. Maybe you can talk to us just a little bit about how investors should be thinking about using money market funds in their portfolio.
Sarah Hammer: Thanks, Amy. It's a great question. Here at Vanguard money market funds are a very important part of our full product lineup. David heads up our taxable money market funds, and Pam Tynan heads up our tax-exempt money market funds. We find that our clients use them for many different purposes, because they have the ability to buy and sell shares for $1 and, for that reason, a lot of clients will use them for many different purposes such as to put aside money for a down payment for a house, or if you're putting aside finances for a child's education and you know you have that tuition payment coming up, or even if you're just managing your daily living expenses. A lot of clients will use money market funds for all of those different purposes.
Amy Chain: That's fabulous. Thanks. I'm taking a look. It doesn't look like we quite have our answers in from our audience yet. David, maybe you could talk to us a little bit about our money funds. David and his team run the funds for us. So talk to us a little bit about your team; how it's structured.
David Glocke: We have a total of seven people that focus on the taxable money markets. It's two portfolio managers, Jack Langis and myself, and then a group of traders that help us to manage the product that we're buying every day. So, on a daily basis, we're coming in and we're getting our cash positions that we need to invest each day, and the traders are out looking across the market, trying to find product that's appropriate for our portfolios. Then we're making decisions about what to buy and what not to buy, adding that to the fund on a regular basis.
Because the weighted average maturity of the fund is only 60 days, the portfolio is turning over on a real frequent basis. So it provides a lot of opportunities for us to go into the market and take advantage of issues that we think add extra value.
Amy Chain: That's great. Thank you. Our polling question results are in, and it looks like the vast majority of our audience, about 66%, use money market funds as a cash management vehicle. Does that surprise either of you?
David Glocke: No, it seems to make sense based upon what we've seen in the past. The portfolios have a very low turnover from the shareholder perspective, so it makes more sense that it's used more as a cash management vehicle.
Amy Chain: And by turnover, you mean we see a lot of people buying our money market funds and then holding them for a long time.
David Glocke: Right.
Amy Chain: So, audience, I'm going to come back to you with a second polling question. That question is: "What concerns you most about money market funds?" Would it be the tone in the regulatory environment, low yields, or risk? While we're waiting for our audience to weigh in on that question, David, I'm going to come back to you.
It's been a while since you've been in studio talking to us about the money market fund world. What's changed since last time you've been here?
David Glocke: Well, the last time I was here, it was at the early stages of the European debt crisis. So I had an opportunity to share with investors what our strategies were at that time, how we were avoiding a lot of the European financial institutions, in particular banks, and especially within the southern periphery, the areas of Greece, Italy, Spain, Ireland, and Portugal.
At the time we were making significant changes in the fund. Since then, we've completely avoided all of the European financial institutions now, and we're investing a lot of those assets in other areas. For instance, we're heavily involved in the Australian banks, the Canadian banks, as well as a lot of treasury in agency securities in the fund, and we're patiently sitting back watching and monitoring the situation. But we haven't made a decision about going back yet.
Amy Chain: I think you've made some important points, because you read that investors are concerned—what's in my money market funds? So it's important to hear. I think we should reiterate that to the clients, that your team is doing their due diligence to make sure that our investments are high-quality. Right?
It looks like the answers to our second polling question are in, and the majority of the clients viewing today are concerned about low yields in money market funds. Again, does this come as a surprise?
Sarah Hammer: Not surprising at all, Amy. It's a really tough environment out there for a lot of investors, and money markets are not immune to the low-yield environment. So it doesn't surprise me at all that people are worried about that. Everybody's feeling it.
David Glocke: This period's been especially tough for savers in the marketplace, and even more so for people who are in retirement and are using the income from their investments to live off of. So it's been a really tough time.
Amy Chain: I think we all feel it here at Vanguard. We read it as consumers. It's hard to get away from the topic of yields these days. But you actually gave us great segue into a live question that just came in. I'm going to throw it out there. Either one of you can jump on it but, Sarah, I'm going to look at your first.
This question comes from John. John asks, "Should I take my money out of the market and go into the stock market at the time when the market is so high?" I think that's a logical sequitur, because I think a lot of people probably have a similar question, "Should I take my money out of money markets now that yields are so low?" What do we think we should be counseling investors to do?
Sarah Hammer: Well, here at Vanguard we're not big fans of market-timing, so I think the way we would answer that question is: "You definitely shouldn't do that." As an investor, what you want to do is have a long-term investing plan. We have investing principles here at Vanguard that really explain how we think about investing, how our clients should be thinking about investing.
The first thing you really need to do is know what your goals are. Why are you investing, both in your investments and your long-term portfolio of stocks and bonds? But, then, today we're talking about money market funds, so I think you want to also know why you're investing your cash. Then, once you know what your goals are, you want to have a long-term plan. You want your plan to be balanced and diversified, and then you want to maintain a disciplined and long-term approach to your investing.
The market's going to go up; the market's going to go down. We definitely wouldn't recommend getting in and out of the market based on what you're seeing in the headline news but rather sticking to those long-term, disciplined principles for investing.
Amy Chain: I am going to hearken back to something you said earlier, which is how investors should be thinking about money market funds. And money market funds or a cash position has an important role in a portfolio, and it should be thought of as just that--a portion of a portfolio, rather than a time to jump in or jump out of any sort of asset class. Is that a good way to think about it?
Sarah Hammer: What we say actually at Vanguard is: "You're going to have your long-term investment plan, and that's going to be your stocks and bonds; that's going to be a balanced and diversified plan that you will practice in a disciplined fashion over the long-term. But then, separately, what you think about separately from that is your cash management, and that's going to be your daily living expenses and an emergency fund that you set aside. So you're going to think of that separately from your long-term portfolio of stocks and bonds."
Amy Chain: That's a great sequitur into our next question, which comes from Anna from Chicago. Anna, thanks for your question. And Anna's question is: "Why a money market fund and not just a normal savings account for this cash management portion of a portfolio? What makes them different, and how should I think of them?"
Sarah Hammer: That's a great question, Amy, and on the minds of a lot of our clients. As we talked about at the beginning of this program, a money market fund is a mutual fund like other mutual funds. So clients in exchange for a fee receive the benefits of professional fund management, a broad level of diversification, and a high level of liquidity.
Amy Chain: Just to be clear on what you mean by a fee, we're talking about the expense ratio?
Sarah Hammer: The expense ratio, that's right. But money market funds are special in that investors have the ability to buy and sell shares for $1, and they're able to do that because of a special rule that governs money market funds. So, for that reason, as we explained, a lot of our clients find money markets very useful for things like putting aside that down payment for a house, where you really want to protect the principal on your cash; or if you're putting aside a payment for your vacation and you want to keep it for the short-term, but you really want to protect that principal. Even if you're just managing your daily living expenses and you're looking for a very accessible, liquid, broadly diversified investment, money market funds are very useful.
Now in comparison to a savings account, to get to the other part of the question, I would say there's probably three major differences.
The first would be credit. When you invest in a money market fund, you're getting a broadly diversified portfolio of underlying credits, and David, and Pam Tynan, and their teams are responsible for investing in those portfolios.
The second would be in a savings account. Often times there will be insurance from the FDIC, which is a government entity that will provide insurance up to $250,000 on your account.
And then I think the third would be that you can link your money market account to your brokerage account. So a lot of clients will find them useful for that purpose. If, for example, you're selling shares of a mutual fund, when you sell your shares, the proceeds of that sale will go automatically into your money market account. Then when you buy your next fund, you can use the proceeds that are in your account to make your next purchase. So those are some of the major differences.
Amy Chain: Subtle but major differences that make one type of an investment or an account more appropriate for one investor versus another. That's great.
Sarah, I'm going to stay with you. You've been talking about protection of principal and safety, and so, Arnold from New York asks, "How safe are Vanguard's money market funds? Is there government insurance and, if so, in what amount?"
Sarah Hammer: Right. Another great question on the minds of a lot of our clients. With all the news that we often see about money market funds, sometimes there's confusion. As we talked about, Amy, there is not FDIC insurance with our money market funds as there would be with a savings account. Last year, in August, David Glocke, and John Ameriks, and I, and some others at Vanguard wrote a commentary that's available on our website to discuss some of our practices in our money market funds, to address some of these questions. We really highlighted five principles that we utilize to manage our funds.
The first is, as you're always going to hear from us at Vanguard, low expense ratios. Our clients are probably familiar with our at-cost structure, which we combine with economies of scale to push down the expense ratios in our funds historically and over time.
Average expense ratios
Expense ratios as of December 31, 2012. Vanguard expense ratios range from 0.02–1.71%. Average expense ratios are represented as a percentage of net assets.
*Sources: Vanguard; 1975-77 Weisenberger Panorama; and Lipper Inc. thereafter.
Amy Chain: Can we talk a little bit about why that's important in a money market fund in particular?
Sarah Hammer: Sure. Well, do you want to take that one, David?
David Glocke: Sure. The importance of that is to keep the expense as low as possible so our investors get as much from the investment as they possibly can. So keeping those costs low, not having to pay shareholders and the rest for equity in the company, allows us to go ahead and provide a higher return. It also gives us another added benefit, which we take advantage of here quite a bit. We keep the portfolio at a very-high-credit-quality level and maintain a high degree of liquidity in the fund, and those assets don't always pay as much as others in the marketplace. We find that our funds can actually be highly competitive in the marketplace because of that low-cost advantage that we have. That lower expense ratio is a key advantage.
Amy Chain: That's great. Thank you. I distracted you. That was number one. Thank you.
Sarah Hammer: David actually mentioned some of the other principles that we talk about in the commentary, which is our high standards for managing the credit in the portfolio, high standards for managing liquidity, and then David and his team work very closely with our credit analysis team, which is a very experienced team of professionals with a lot of years of experience in finance, who perform the fundamental analysis for every security that gets purchased by the portfolio.
David Glocke: The credit team is really our front line defense. They're out there making the decisions about what credits are eligible to go into the fund—those that meet Vanguard's standards for purchase in the money market funds. They'll make an independent credit decision, and then those names are added to our approved list, and that's the list that the traders and I use to decide which securities we may want to invest in or not invest in.
Then on top of that, they monitor those credits on an ongoing basis for changes in the market, changes in conditions that might influence whether or not we want to continue to invest in those securities. So they're really, like I said, the front line, and there's a total of 23 senior credit analysts on our team with a full staff that supports those people.
Sarah Hammer: That's an important nuance because I think the general public knows a lot about the rating agencies, but it's important to know that we have own internal rating agency, so to speak, that looks at every investment that our teams make pretty closely before it's even on the table for investment.
David Glocke: True. The regulators actually require that Vanguard does its own independent analysis. We don't rely on Moody's, and S&P, and others to make the decisions for us. We actually do our own internal ratings, and our credit analysts make a decision about what credit quality they would apply to a particular security. We use that in the investment process.
Amy Chain: That's great. Did we get through all the principles? I lost track of our count.
Sarah Hammer: I think the one thing we didn't mention, Amy, is we discussed in the commentary something we do call "guarding against disruptive redemptions" in the portfolios. That's kind of a fancy way of saying that we try to protect against in situations where a large, concentrated investor will quickly or suddenly withdraw money from the portfolio because, when that happens, it can be very costly to the remaining investors in the portfolio. There's a name for that in the industry, which is "hot money."
The way we try to guard against that is we ask several questions of a potential client that might have a multimillion dollar or more investment in the funds. We try to ascertain: What's the nature of your investment? Are you investing for the long run or are you just waiting for the next best thing? Are you looking for just an extra basis point or two, and then will you be moving on to another portfolio? Based on that we have been known to turn away "hot money."
Amy Chain: That's important to note as well. I think it's a competitive advantage of ours that we look to protect our existing shareholders. We don't just do the easy thing, which is to take money when it comes your way; we make sure it's the right money before we say yes.
That actually brings us to a live question that just came in from Adrienne. Thanks, Adrienne, for your live question. Adrienne asks, "Why are some of our money market funds closed?" I think you started to talk about that conversation, which is that we look closely at cash and, maybe, David, you could talk to us a little bit about that.
David Glocke: The Admiral Treasury Money Market and the Federal Money Market are both closed. That really goes back to the more volatile periods in the post-Lehman environment, where we saw a tremendous flight to quality. Plus investors who might have been in other types of products became nervous about the market, not just money market funds but equity funds and bond funds.
They were looking to move money into very high-quality assets, in particular, U.S. Treasury securities, and the prices of those securities rallied so much, and the yield differential between the current yields that were in the portfolio versus what was available in the market would have resulted in us deluding the yield of the fund for the long-term investors, and we made a cautious decision not to do that. We wanted to protect the yield for those long-term investors. So we closed the funds to new investments.
In the current environment, we've kept them closed primarily because the yields are so low right now that it would be uneconomical to expand it at this time.
Amy Chain: Thanks for the live question, Adrienne. David, I'm going to stay with you here. We have a question from Richard from New Jersey. Richard asks, "How or where does Vanguard invest the underlying amounts and insure that there is satisfactory liquidity for redemption?"
David Glocke: As far as the liquidity perspective, we're required by the Securities and Exchange Commission to have a mandatory 10% daily liquidity and at least 30% weekly liquidity. That's one of the rules that came out of the 2010 SEC amendments. Prior to that, we generally looked at the portfolio just to make sure that we had a high degree of liquidity for our investors based upon long-term performance, and then would adjust the portfolio periodically to increase that when we felt it was necessary. But in today's environment, the SEC does regulate that very closely, and that information, of course, is available on our website too.
In addition to that, we continue to monitor the types of credits that we're purchasing. We want to make sure that we're buying issuers that other investors would be interested in purchasing also. So if at Vanguard we decide we want to get out of a particular issuer, that there's still a broad market of potential buyers that would go ahead and purchase the security.
Then finally, on top of that also, when we think that there are times when there's an increased level of market risk where liquidity might be constrained, we'll increase our ownership of U.S. Treasury and agency securities. So if you go back to the 2008 period before Lehman went bankrupt, we had over 50% of the fund in U.S. Treasury and agency securities, which was more of a concern of ours about market risk and wanting to enhance the liquidity of the fund.
Sarah Hammer: One thing I'd just add to that, Amy, which Dave didn't mention but some of our clients may not know, it's kind of implicit in the conversation, is that our money market funds are actively managed. So that means that our portfolio managers have the abilities to strategically reposition a fund when it's appropriate, and you can see that in how David and Pam manage.
Amy Chain: That's a good point. Glad you added it.
David Glocke: Yes. The credit team again is that front line of defense, but then from the portfolio management perspective, we kind of look at the big picture view of the world and how the economy and the rest is evolving, and given conditions like, for instance, the European crisis, we recognized early on that there were concerns and how that could impact money market funds. We made appropriate adjustments in the portfolio, added more Treasuries and agencies, and let the investors know about that.
Amy Chain: I'm chuckling because I could swear you could see my screen. The next question I was going to ask you comes from Robert in Oklahoma, who says, "In view of the current economic situation, how does Vanguard hedge its risk in the prime fund?"
David Glocke: Yes, it's a good question. In a lot of ways, it's very much the same as what we did back in the 2007 and 2008 period, as well as 2010 and 2011 with the European crisis. We very closely monitor the credits that are in the portfolio to make sure that they're still representative of the type of risk that we're willing to accept. Then again because of that low expense ratio advantage that we have, I know I can go out and I can buy U.S. Treasury and agency securities to go ahead and keep the liquidity and the credit-quality characteristics of the portfolio at the level that we want to maintain. So even on a day like today, given the economic conditions and our markets starting to improve a little bit, we're still concerned about the issues that are taking place on a global scale, in particular Europe and the rest, and so that we still have at this point 50% of our assets wrapped up in U.S. Treasury and agency securities.
Amy Chain: That's a great point to reiterate, I think again and again, frankly, and that's that our expense hurdle—we've eliminated a giant hurdle by keeping expenses low. We don't have to reach for yield, you can—it sort of takes a lot more of the expenses—take a lot of that out of the equation for you. It's great.
Okay. Sarah, let's send a question your way. This comes from Richard in Massachusetts. Richard, thanks for the question, "Depending on your net worth, is there any advice or rule of thumb that suggests what percentage of your investable assets one might keep in cash?" "With greed aside," Richard says, "one only needs so much money to be comfortable. Why invest it all?"
Sarah Hammer: That's a good question and on the minds of a lot of our clients right now, who are thinking about how to manage the cash that they have and may have adjusted their portfolios. We actually wrote a commentary on that last year as well. It's called Managing cash in your portfolio and our clients can find it on our website. In that paper we discuss how you should really think about cash separately from your long-term portfolio of stocks and bonds. What you need to do is kind of sit down and think about, first, your daily living expenses. How much do you need to live on a day-to-day basis? What are your expenses? When will they come due? And what are your assets that you have to allocate to that?
And then secondly, and separately, you need to think about an emergency fund. What kind of cash do you want to set aside if something happens and you're going to need to break open that piggy bank?
Once you've done that, then what we say is you should match the need with the investment. So, for your daily living expenses, you're going to want an investment vehicle that's very easily accessible. When we say accessible, we mean, you're going to want to be able to view it online maybe or you might want checkwriting capability. You're going to want to ask if there's an ATM card.
Then for your emergency fund, you're also going to want a principally protected product. You want a place where when you put your money in, you know that that principal is going to be protected in case you need to get to it.
There's a lot of different options on the menu for both of those two things. Money market funds being a great option because of that stable $1 net asset value. A lot of clients find them useful both for your daily living expenses and for your emergency fund. That's kind of how you're going to think about it. So, unfortunately, there's no rule of thumb but that's how you'll think about planning your cash in your portfolio.
Amy Chain: That's great. Thank you. I'm going to change gears a little bit for us. We've got lots of questions on this topic. We've certainly seen lots of headlines on it and that's just generally, sort of, what's the regulatory environment like for money market funds? Judith, in particular, from Ohio asks us: "What kind of changes are happening?" Maybe we could talk at a high level about what we're seeing in the regulatory environment.
David Glocke: On the regulatory front, the SEC went through sweeping changes on money market rules back in 2010 that we needed to respond to. Vanguard actually played a key role in helping to go ahead and put some of those thoughts together that went into the final draft of the SEC.
Those changes are now fully implemented, and the regulators have been given sufficient time to kind of view how those changes are being implemented and how they're evolving over this period. I know there's been a lot of talk, newspaper stories and the rest talking about potential further changes that the regulators may impose. We really can't speculate on what that might end up being, but we tend to think that there could be some significant issues related to retail versus institutional type of portfolios. We saw the SEC try to do that back in the original 2010 draft but it was pulled out. So it's possible that they come back to that and implement something with an institutional/retail split.
Amy Chain: Thank you for tackling that question. Let's go to Jeffrey from Arlington, Virginia. Jeffrey, thanks for your question. Jeffrey says (Sarah, I'm going to send this one your way), "I have a prime portfolio but feel I have too large an amount in it—about a year's salary. I'm uncertain about other safe investments. What are your thoughts?"
Sarah Hammer: It sounds like, Amy, there might be sort of two questions there. The first is kind of how much should I be setting aside and the second is where should I put it? Which is a big question especially in a low-yield environment.
In terms of how much you set aside, thinking about the first part of managing your cash and your daily living expenses, it's really a very individual question. You kind of have to sit down and say, "When I'm going to have to write my rent check? When is that tuition payment going to be due? When is my mortgage payment going to be due?" Then think about if you're going to have enough money set aside to meet those expenses.
In terms of where you should invest your money, again, for daily living expenses accessibility is key—so having an ATM card, having checkwriting capability, maybe the ability to see your account online. You're going to want something very liquid, which means you'll be able to get in and out of your cash easily. There's a lot of different options on the menu, some money markets, of course.
Accessible options include a savings account or a checking account. If you're looking for something that's potentially a little bit less accessible, you might consider CDs. But there's trade-offs to every kind of investment. So the key thing for you as an investor is to know what's important to you, what's your top priority.
If you're most concerned about principal protection and accessibility, then a money market fund makes a lot of sense because of that $1 net asset value.
Amy Chain: It sounds a little bit like before you can answer the question how much, you have to answer the question, well, what's it for?
Sarah Hammer: Right. What's important to you? You might move into a CD, for example, but if you find that you need the cash sooner than you thought you would, then you might have to pay a fee or you might have some kind of penalty when you cash out that CD. So accessibility is important. Liquidity is important. Yield is just one of many concerns, and it's not necessarily the primary concern when you think about investing your cash.
David Glocke: And with the CD products, also, investors are required to lock up their money for months or even years, and without that accessibility you really remove one of the key elements or the advantages that the money market offers.
Money market investors, in general, they swim in the shallow end of the pool. They're not looking for a lot of risk. They're taking risks in other parts of their portfolios. But over time if you find that you've accumulated more than what you really thought you should in a particular avenue, it may be worth examining your broad portfolio and making appropriate adjustments where necessary.
I know that when my wife and I were young, we used to set money aside in a money market fund to invest periodically. Every once in a while we didn't pay attention and pretty soon we realized we had more there than we really intended. But that was a good opportunity to go ahead and reassess where we wanted to be and make the appropriate allocations, and over time we've gotten a little better at that.
Amy Chain: Great point. I wish we were finding more money in our personal little money market account than we thought, these days, but—
David Glocke: It's when you have kids. When the kids are young, you're paying attention to something else.
Amy Chain: Let's see, where are we here? All right. Sarah, I'm going to come back to you. This question comes in from Jody from Montana. Jody, thank you for your question. It's along the same lines: "For an emergency fund—let's say you're setting cash aside as an emergency fund—do you have any recommendations about where to invest and how much?"
Sarah Hammer: Good question. When it comes to your emergency fund, there's a very broad range of how much you might want to set aside and it's a very individualized decision. What we say here at Vanguard is that it can range anywhere from three to 36 months of living expenses and that's an extremely broad range. But if you think about it, it makes sense.
If you are, for example, someone that has really specialized skills, and if you were to lose your job and lose that source of income, and you had deep concerns about finding another job like that; suppose you're also very risk-intolerant, then you might want to have a really big emergency fund.
If you're someone who is not as worried about finding employment if you were to lose your job and you have pretty low living expenses, then you might have a smaller emergency fund. So it really depends on your individual circumstances. But you really should think about it. Then when you do set aside that money, you're going to want to put it into a product that's principally protected.
Another thing to think about when you set aside your emergency fund or even your cash for daily living expenses is that you give up two things when you set aside cash. The first is yield, as we talked about here today. The other thing is that you don't track inflation. Those are things you should be aware of when you decide how much to put aside for an emergency fund.
Amy Chain: That's a great point. We were here just last week with Karin Risi of Vanguard's Advice Services, and Karin's advice to our audience was, essentially, if you can sleep at night, that's a good barometer. If you're up worrying about whether or not you have enough set aside, it may be time to revisit your plan and decide if you have enough set aside.
Sarah Hammer: That's a good one.
Amy Chain: Let's see. Let's go to Jay. Jay asks: "Are there reasonably safe investment alternatives to money market funds that offer significantly better returns?" Boy, I'd like to hear the answer to this one.
Sarah Hammer: Right. If we could waive our magic wands, right?
David Glocke: Yes. It's a tough issue but I think, ultimately, Jay's got to realize that with any type of investment, the more return you want the more risk you have to be willing to accept. If you're primarily one of those shallow-end-of-the-swimming-pool-type investors that doesn't want to have a lot of risk in that portion of their portfolio, it's tough to find alternatives.
Sarah Hammer: There's a concept in fixed income in bonds, or bond funds, and the money market funds called "duration," and duration is one of those finance words for how much risk you have in your bond or in your bond fund. The longer your duration or the bigger that number, the more risk you're taking. So in a money market fund, the risk is obviously shorter, because the weighted average maturity or the maturity of the securities in the portfolio is going to be pretty short.
But if you take on more risk to get more—if you take on more risk to get more yield—you're taking on more risk.
Amy Chain: You're taking on more risk.
Sarah Hammer: Right. Unfortunately, there's no free lunch; there is that risk return trade-off, and that's something investors have to keep in mind.
Amy Chain: That's great. Thank you. Sarah, I'm going to stick with you for this one. This comes from Tom from Farmington Hills, Michigan. Tom asks, "When is it better to use a tax-exempt money fund versus a taxable money market fund since both pay such low interest?"
Sarah Hammer: That's a good question and it's definitely hard to make the distinction these days. With yields being so low, a taxable money market fund probably looks very similar to a tax-exempt money market fund. But some day, when yields do rise, then the difference might be more noticeable. Then with tax rates having gone up for those in the highest tax bracket, it's definitely something to think about.
Our taxable money market funds include Prime Money Market Fund or Treasury Money Market Fund. Then on the tax-exempt side, those funds will invest in tax-exempt municipal securities.
As an investor you're going to want to compare the two funds, and there's a way you can do that using something called a "tax-equivalent yield," which is kind of a fancy term for looking at the yields of a taxable fund versus a tax-exempt fund and kind of figuring out what would be fair if I was in a taxable fund versus a tax-exempt fund?
So, if you're considering the two, that's something you want to do.
Amy Chain: Any suggestions on where investors might be able to find information on that? Is this stuff that's available on vanguard.com?
Sarah Hammer: You can definitely find information on vanguard.com. It might be a good question for your advisor as well. The other thing to think about is really the location of your cash. For example, if you're holding cash in a taxable fund, then you might consider a tax-exempt money market fund. But if you hold your cash in a tax-deferred account, then you might consider a taxable money market fund.
Amy Chain: That's a great rule of thumb. I'm going to ask you to repeat it for the audience.
Sarah Hammer: If you are holding your cash in a taxable account, then you might consider a tax-exempt money market fund. But if you're holding your cash in a tax-deferred account, then you might consider a taxable money market fund. So that's something to think about as well. Location is important.
Amy Chain: Location, location, location.
Sarah Hammer: That's right.
Amy Chain: Thank you. Let's see what we have up next. David, I'm going to come to you. He's been silent for too long. Janie from Massachusetts asks: "I've been in money market funds since they were yielding 18%. I'm reluctantly moving to CDs. Is there any chance that money market funds will ever again equal short-term CDs for yields? I'm also wondering whether there is now a risk of principal loss with the interest rates non-existent."
David Glocke: We're in extraordinary times right now. We've gone through a major financial crisis in the United States and the rest, and it's caused the Federal Reserve to have to bring interest rates all the way down near to zero. Then on top of that go through other extraordinary measures. So this is a very unique time period that let's hope we don't have to go through again.
Interest rates are obviously exceptionally low as a result. At some point in the future, this is going to change. We're starting to see some improvement in the economy. Car sales are strong although not quite back to where they were previously. We've seen a resurgence in the manufacturing sector. Home sales have been drifting higher. It's really encouraging signs. Yet just the same growth in the United States as measured by the gross domestic product (GDP) remains fairly weak. Things are just okay there.
But as the economy continues to improve, the Federal Reserve will be at some point in a position where they'll have to raise rates again and things will move back to normal over time. So we just have to hang in there and stick this out until conditions improve.
Regarding the issues about losses and the rest of it, even in this low-interest-rate environment, we'll continue to go ahead and employ the same strategies that we always do to protect the funds against losses. So we continue to have our credit teams expanded to look at more options that are available to us in the marketplace. We still have a broad group analyzing that. We continue to watch very closely other conditions as they're shifting in the economy to see where opportunities are and, like I said, in the present environment we still maintain 50% of our assets currently in U.S. Treasury and agency securities. So I think we still maintain that high Vanguard credit-quality perspective, and the overweight to U.S. Treasury and agency securities, in particular.
Amy Chain: All right. I'm going to throw a live question in here. You touched, David, I think earlier on laddering CDs. David asks, "Please compare the pros and cons of a money market fund versus a ladder of CDs." Turn it over to either one of you.
David Glocke: You want me to take it? The laddering strategy allows an individual investor to go out and buy a series of fixed maturity investments that have regular cash flows that come due versus simply investing your money into a money market fund. The key difference between the two, if interest rates remain low for a very long period of time, those cash flows could be higher in a laddered portfolio. But when interest rates turn and they start to move up, the individual in the ladder portfolio is going to be locked into those particular maturities and, in particular with a CD, you may not have access to the cash to be able to pull it out and reinvest it another product.
The money market fund will respond more quickly to changes in interest rates. So when we get back into a rising rate environment given the short maturities that we purchase, we're able to go ahead and reinvest those maturities in higher-yielding assets as they become available. So a little different strategy for different environments.
Sarah Hammer: Another important thing for clients to think about, Amy, if you're thinking about laddering, is that it can be a very labor-intensive process. So, as David mentioned, for example, if I wanted to build the CD ladder, I have to decide what's the maturity of my CDs. So I might say, "I'm going to buy a three-month CD, a six-month CD, a nine-month CD, I have to decide how much cash to put into each rung of the ladder." Then when things roll down, so three months from now, my three-month CD is zero and everything else is three months less, I have to say, do I need this cash now or am I going to put it into a new nine-month CD?
So it can be very labor-intensive, and it's definitely something to think about, if you're willing to continue to maintain and make those decisions over time, then it can be something that's effective for you. But you have to be aware of the maintenance involved in building and maintaining a ladder.
David Glocke: That's an important point.
Amy Chain: That's great. Thanks for the live question, and I'm going to encourage you, audience, to keep sending us your questions live if you have them; remind you that we are on Twitter, so if you're on Twitter and you have a question, send it to us at #VGLive. I'm keeping an eye out there, but I don't see any questions coming our way quite yet.
So, in the meantime, Sarah, let me send another one your way. This one comes from Jan from Colorado, and Jan asks: "With super low interest rates on money market funds, are short-term bond funds a reasonable substitute?" I think this is an important question and one that I want us to answer very seriously because we hear it a lot.
Sarah Hammer: It is. We are hearing it a lot; we're seeing it a lot with our clients, Amy. Obviously, everyone's feeling the low yields across the board and our people are very concerned about how to get that extra yield. Looking at a bond fund in comparison to a money market fund can be pretty complicated. When you think about what your goals are for managing your cash, one of your primary goals may be to protect principal. We talked about the concept of duration. A bond fund has a much longer duration; it's much riskier than a money market fund, so it's not a true cash management vehicle because it does have duration risk.
When you compare the average maturity of a money market fund, which is going to be 60 days or less, to even a short-term bond fund that's going to be risky, have a duration of two, for example, you're talking about essentially a much riskier instrument. So, if you're looking to protect cash, if what you want is a true cash management vehicle, then a bond fund is not necessarily the right choice.
Amy Chain: Great. Thank you. Anything to add while I'm glancing at my screen?
David Glocke: On the bond fund side, a lot of investors made an asset allocation switch, and we saw a lot more money move into the fixed income market early in the financial crisis. It went into corporate bonds. It went into Treasuries. Even our index bond funds saw enormous flows that were coming into them. A lot of the extra return that comes from the decline in yields has taken place in some of these portfolios.
As the Federal Reserve has stepped in to manage interest rate policy and to drive rates lower, all of those efforts have helped to keep rates down. When the Federal Reserve started purchasing U.S. Treasuries or mortgage-backed securities directly, that went another step further to help bring those rates down.
Investors that have been in those funds have had extremely high returns on a relative basis, historically. It's a little tough right now at this particular juncture. Fixed income portfolios should still be part of people's core investment. So there still should be an allocation. But as interest rates rise, those portfolios will adjust too.
The advantage on the bond fund is that, as dividends come due in the portfolio and the rest, as well as maturities in the fund, those will be reinvested at higher yields. So the investor will have a chance to go ahead and realize some of the appreciation that's taking place also in that particular market.
So part of the strategy is, don't change if you're already there. Enjoy what you've had. It's great and, even better, to go ahead and stay diversified.
Amy Chain: I think what I hear you saying is bond funds make a great bond portion of a portfolio. But think real hard if it's a cash management or a cash position that you're looking for.
David Glocke: Yes. Again to make the leap to go from a money market fund to, let's say, even a short duration bond fund of two years, like you mentioned—
Sarah Hammer: It's a pretty big leap.
David Glocke: It's a big leap. U.S. Treasury securities yield approximately 25 basis points in the two-year area. So it doesn't take much of an increase in yield to go ahead and wipe out a whole year's worth of income in a portfolio like that. So it is something that you need to be cautious about.
Sarah Hammer: Right. In other words, by reaching out in duration a little bit you can easily see your returns wiped away when rates do rise.
Amy Chain: Sarah, let's answer a question from Louis from California. Louis says: "Instead of parking investments in a money market fund, is it not better to invest in a California tax-free bond and then exchange some money into the other fund when the time is right?" Parenthetically, he says: "(When the market is moving up.)"
Sarah Hammer: Another good question, which is kind of along the lines of bond funds that we've talked about. If your objective as an investor is true cash management and you're looking to protect principal, so you're putting aside money for your daily living expenses or you're putting aside your emergency fund, then investing in bonds doesn't make sense, because it's not a principally protected instrument. It's a duration-risky investment. Investing in a tax-exempt bond would not necessarily make sense in that case. Then again, going back to when David and I talked about building a CD ladder, you're going to have the same issue with investing in bonds.
If you were to put your cash into bonds, you'd have to build a ladder. You'd have to decide on the maturities, the amounts, the rungs, and then you'd have to maintain that ladder over time. So that's definitely something you want to take into account.
Amy Chain: I think Lewis brings up an important point that a lot of investors are thinking about, and that is if you have been parking on the sidelines for a while and you would like to start getting back into the market, how should you be thinking about doing so? Maybe you can share some expertise?
David Glocke: Again it goes back to formulating a long-term game plan, and adjusting your portfolio, and sticking to that game plan. Realizing that when markets are volatile, sometimes it's better just to go ahead and step away, and just let the markets do what they do, because if you have a long-term game plan and stick to that, you're probably going to be much happier over time. If you try to time the market, that's when all of a sudden you start to interject your own thoughts and ideas, and you may go ahead and hit some of those marks well, but on the other hand, too, as the caller is referencing, maybe they didn't go ahead and get back in early enough. It's one of the core principles that we have here—is to stick to your long-term plan and, in particular, also to stay with low-cost options that Vanguard provides.
Sarah Hammer: If we felt there was a way to share with our audience to time and get back in at the right time, we would share it. Right? But we don't think there is.
David Glocke: Yes, today the stock market is hitting new highs, interest rates are at historic lows, and it's difficult if you've been on the sideline. I understand the volatility that we saw in the equity market, in particular in 2008 and 2009, caused a lot of people to reassess their positions. But for a lot of investors who stayed with their plan, stuck to the core, they've probably been much happier and not calling in today, as maybe some others are.
Sarah Hammer: We've done a lot of research here at Vanguard, Amy, on investor behavior. Based on that research, we've really developed our investing principles and, as we talked about it earlier in this program, having that long-term investment plan and really sticking to it will yield much more fruit over time than trying to time the market. So have an investment plan. Know your goals. The plan should be balanced and diversified, and then maintain a disciplined and long-term approach to investing. That's really what's going to pay off over time.
Amy Chain: Sometimes that's the hardest part if you're watching the market bouncing, but you know that you committed to, say, dollar-cost averaging, you have to stick with it. You have to keep, stay with your plan, and execute on it as you committed to doing. That's great.
Sarah, I'm going to ask you another question. It's somewhat repetitive to some things you've answered, but the questions are still coming in from the audience and I think it bears repeating. So Catherine from California asks, "Where can one make some interest and income safely today?"
Sarah Hammer: Right. Another question along the lines of how can I get a little bit more yield in the current environment without taking on risk? Again what I would say is: "Unfortunately there's no free lunch." You know, there's low yields across the board. We're all feeling it. As a cash investor, when you're thinking about investing your cash for your daily living expenses and your emergency fund, your first concern is going to be principal protection. So yield might not be your primary concern. You want to keep in mind this concept of duration that we've talked about today. If you reach for maturity or you're looking at a bond fund or bonds, for example, then you're going to be taking on risk and your principal won't necessarily be protected. So, unfortunately, there's no place where you can go to pick up yield that's going to be 100% safe.
But what you really can do as an investor is know what your goals are, know what your objectives are, and then match your investment to that need.
Amy Chain: I love it. Maybe you can repeat that one more time for our audience. Know what your goals are.
Sarah Hammer: Know what your goals are. Know what your objectives are, and then match your investment to the need. It's very, very important, especially when you're investing cash in an environment like we're currently in. Instead of thinking about what's going on in the news, you kind of have to tune out all the noise and say, "I'm investing my cash for principal protection. Here's the right instrument for me."
Amy Chain: That's great. David, I think we have enough time for maybe one or two more questions. So I'm going to combine two and send them to you here, because I've seen them come up several times. I'm combining questions from Robert and William from Colorado and North Carolina. That is, "Why are interest rates so low and what do we think is in store over the near term for interest rates?"
David Glocke: Okay. The Federal Reserve reacted to the financial crisis in 2008 by lowering interest rates aggressively. Stock market dropped over 50%. They continued to drive interest rates lower to try to stimulate the economy. Historically, when the Fed lowered interest rates, generally in a recession, individuals would go out and start to borrow. Banks would see the demand that might be in homes, cars, whatever. But we would see additional economic activity that would go ahead and drive growth, spur it, and put us back to where the economy needed to be. Then the Federal Reserve would step in and pull that excess liquidity away, adjusting interest rates back up. That's how the economy normally works through its cyclical period.
Unfortunately, in this particular one, this was a severe financial crisis that resulted in a lot of individuals realizing they really had too much debt. So what we've seen on top of the normal recession is we've seen kind of a deck-deleveraging initiative that's taken place.
Consumers now are more sensitive as to how much debt they have on their own balance sheet. Part of that is a direct result of the housing bubble burst and the rest, and people losing their jobs accordingly. So, you know, the Fed has used its traditional tools, brought interest rates down as low as possible. That's what the Fed always does. But in this economy, with people trying to deleverage, there are fewer people that want to go out and borrow money even though interest rates are exceptionally low.
The Federal Reserve has stepped in now and instituted a number of new policies. They've used quantitative easing, where they've gone out and purchased additional securities and that purchasing activity actually causes the supply of money to increase. So, in the same way of lowering interest rates, we'll tend to go ahead and do something like that. The Federal Reserve had done it directly and, again, it hasn't really resulted in enough strength in our growth at all to go ahead and push us back up into better conditions like we've had in the past.
That's why I said we've had a very slow, positive economic growth cycle that's developing here. Housing is starting to turn. Certainly the auto industry is turning. Manufacturing is getting stronger, but just the same consumers aren't levering up like they have in the past. So this may just take an extended period of time before we grow out of it. You can add to that also, too, the troubles that we've seen around the world. Europe is having their own difficulties. We've seen Asia slow down dramatically. So on a global basis growth is slowing. Growth in Europe should be negative this year. It's going to take an extended period of time; we have to be patient. But I suspect that the U.S. will probably be the first country that goes out and fully recovers from this. We were the first ones to go into it. We reacted very aggressively. The policies that are in place are starting to go ahead and bear fruit, and I would anticipate that probably this year and next rates remain very low, but after that there's a good shot that we start to see a potential increase in interest rates.
Amy Chain: Well, I'll take that as good news. That sounds like good news to me.
David Glocke: It'd be fantastic news because if we start to see interest rates going up, it's probably a good sign about the economy, and growth coming back, and unemployment heading and declining further. So it would help, in general, the whole economy recover.
Amy Chain: Sounds good. Unfortunately we're getting short on time. So I think we're going to have to end it on that positive note. Anything either of you would like to add before we close today?
Sarah Hammer: I would just reemphasize what David said. In the current low-yield environment, really thinking about expenses is particularly important. If you're looking at low-yield products across the board, you really want to be sensitive to what kinds of costs you have in your funds. Investors across the board are concerned about low yields, we're all feeling it. But if you're managing cash, you want to focus on what your goals are, and your objectives. And protecting principal might be your primary concern more so than picking up yields.
David Glocke: Also, I think that given this low-yield environment I really appreciate how investors have stayed with us, and the rest. We understand that initially we were concerned that we would see more cash leave the portfolios. It's been just the opposite, and I think that really speaks significantly to how investors at Vanguard use their money market account. It's not necessarily an interest-earning vehicle, per se, and it is more of a tool that's used as part of their broad cash management strategies, and the rest. So it's a real testament to the fact that I think people out there are listening.
Amy Chain: That's great. Then we'll say thank you to the audience for sticking with us and our money market funds and also sticking with us here today. So from all of us here at Vanguard, we want to say thanks for spending your afternoon with us. In just a few weeks you'll receive an e-mail from us with a link to a replay of today's webcast along with a transcript. If we could just ask you for a few more minutes of your time, a survey should be appearing on your screen now. We'd love to hear what you think. So from all of us here at Vanguard, have a great day and we'll see you next time. Thanks.
All investments, including a portfolio's current and future holdings, are subject to risk.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
For more information about Vanguard funds, visit www.vanguard.com or call 800-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.
Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal alternative minimum tax.
While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.
Diversification does not ensure a profit or protect against a loss in a declining market.
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