Money-Market Funds Dial Up the Risk

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The latest financial crisis changed the way many American view investing, perhaps permanently. These events brought many storied financial institutions like Citigroup (NYSE: C) and even government-sponsored enterprises like Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) to their knees. Trust in Wall Street and the people who run our financial institutions has been damaged, thanks to the excessive risk-taking behavior many of these captains of industry demonstrated. And now that it looks like the worst is behind us, some managers are getting right back to juicing up portfolio risk.

How soon we forget
A recent Wall Street Journal article highlighted the fact that some money market funds are going out further on a limb in search of higher yields. While many such funds retreated to the safety of very short-term instruments in light of last year's financial panic, now these funds are buying longer-term securities and taking on additional risk. Faced with a dwindling supply of high-quality liquid investments, some money funds are moving from Treasuries to corporate debt in order to boost yields.

The risk in moving into longer-duration securities is that if interest rates rise, the value of the longer-term securities will fall, since they will be yielding less. And given that interest rates are near historic lows, odds are that rates have nowhere to go but up. With the economy still struggling to gain its footing, rates won't go up anytime soon, but it's possible we could see a rate increase by as early as mid-to-late 2010. That could put funds that hold slightly longer debt instruments at risk.

Lessons learned
So are money managers ignoring recent lessons about taking on additional risk? Well, while there may be some selective short-term memory loss involved here, I'm not pressing the panic button just yet. We're far from being in economic boom times, but the state of our financial system has improved tremendously from the panicky days of last fall -- the performance of financial stocks like Goldman Sachs (NYSE: GS) is just one sign of how far we've come. While you can argue that long-term structural economic problems still exist, an adverse credit event is much less of a possibility now. Market and credit risk are much lower now, which makes the idea of bumping up portfolio risk a bit more palatable.

Moving slightly further out on the duration curve is a reasonable effort to squeeze a bit more out of returns, given the current environment. With yields so low and with such a short supply of high-quality short-term securities, money fund managers are doing what they can to keep their funds competitive. After all, that's what you're paying them to do -- identify areas of opportunity and take advantage of them. Of course, that's not to say that one or two money-market funds may not get caught with their pants down if we encounter another unanticipated financial shock, but I don't think money fund investors in general should worry about the safety of their money, even if durations across the board inch up a bit.

Keeping tabs on your money
Ultimately, investors should still exercise caution when choosing a money market fund. You want to pick a solid, low-cost option, preferably from a larger financial institution that has the resources to help out their funds if they do run into trouble. And be wary of any funds that tout yields that are significantly higher than its peers -- odds are good that the fund is investing in lower quality or riskier securities to get that extra yield.

According to Morningstar data, money market funds are available from financial institutions like HSBC Bank (NYSE: HBC), JPMorgan Chase (NYSE: JPM), and M&T Bank (NYSE: MTB). However, I think fund shops Vanguard and Fidelity offer two of the better money market fund options. If you're looking for a safe place to stash cash, consider Vanguard Prime Money Market (VMMXX) or Fidelity Select Money Market (FSLXX). Both offer steady, consistent returns with a low price tag, a must for this kind of investment.

Like you would with any of your investments, it's vital to keep an eye on what's going on in your portfolio as the economic environment changes. So while some money market funds may be walking a bit further out on the risk ledge, I don't think there's any reason to worry about them taking a header -- yet. Let's just hope managers have truly learned the lessons about risk that the latest financial crisis has offered up.