Look closely at cash assets

Have you looked at your money lately? Not your brokerage statement, your cash accounts. Most people have been too concerned about the gyrations of the stock markets to spend much time worrying about their “safe” cash investments. Well, now that the markets have stabilized, at least for the moment, you should turn your gaze elsewhere.

For years, I’ve taken the position that no one should keep any large amount of money in bank savings accounts. The interest they pay is virtually non-existent. Some smaller financial institutions and aggressive marketers like ING Direct will give you higher rates (ING has been offering 2.75 per cent on their Investment Savings Account with no minimum balance required). But you have to shop for the deals.

Simplicity of money market funds attractive
The easier route for many people has simply been to switch their cash balances from savings accounts to money market funds. Since all major banks offer them, it’s been a matter of simply sliding down to another counter to set up a mutual fund account and arrange for the transfer. This strategy worked fine for years and many people still rely on it. As of the end October, Canadians has more than $60 billion invested in domestic and foreign money funds with member companies of the Investment Funds Institute of Canada (IFIC).

However, some money fund investors have been noticing that their returns have been drying up. They pulled almost $4 billion out of these funds in the first 10 months of the year, according to IFIC statistics. What’s particularly striking is the fact that gross sales for all categories of equity funds are ahead of redemptions this year, despite the chill of the bear market. In other words, the big exodus from mutual funds that has made news headlines in recent months has hit money funds the hardest.

An analysis of the performance numbers provides an explanation. The average Canadian money market fund gained just 1.59 per cent in the year to Oct. 31, according to figures published by Globefund. Funds with high management expense ratios (MERs) fared much worse. In some cases, profits have almost vanished.

Next page: High MERs equal loss of profit

High MERs equal loss of profit
Take the Acuity Money Market Fund, for example. It has one of the highest MERs in the category, 2.43 per cent. This means that until the fund gains more than that, you receive nothing. With interest rates so low, nothing is just about what investors have been getting. For the six months to Oct. 31, the fund returned a paltry 0.08 per cent. That’s right, only eight-one-hundredths of a percent. Investors have almost $8.5 million in this fund. Clearly, they aren’t paying attention.

Granted, that’s an extreme example. But if you scan down the list of Canadian money market funds, you’ll find that the majority show six-month returns of less than 1 per cent. There are very few that are in the category of the Leith Wheeler Money Market Fund, with a 2.75 per cent advance, thanks in part to the low MER of 0.6 per cent.

U.S. money funds fare even worse
The picture is even worse when you shift your gaze to U.S. money funds. Here the one-year average return is actually below 1 per cent (0.88 per cent, to be exact). And the recent half-point rate cut by the Federal Reserve Board is only going to exacerbate the situation. Unless short-term rates move back up quickly, it’s difficult to see how a fund like Trimark U.S. Money Market (DSC units) is going to make any profit at all in the next 12 months, especially given its MER of 1.58 per cent.

What to do? Here’s one rather unorthodox suggestion: shift your money market fund assets into a no-load, low MER mortgage fund. All the banks offer them. The risk is slightly higher because if short-term rates rise, you could suffer a temporary capital loss. And in fact, the average mortgage fund lost 0.06 per cent in October. But that’s a rare occurrence, and the higher return potential more than offsets the risk. Over the past six months, for example, the average mortgage fund gained 3 per cent.

Don’t forget flexibility
Just be sure to choose a no-load fund so you have full flexibility to get your cash out at any time without penalty. When interest rates start to rise again, money market funds will be the better bet.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail investment newsletter that features some of Canada’s top financial experts. For membership information: http://www.buildingwealth.ca/Newsletter/index.cfm

Gordon Pape’s 2003 Buyer’s Guide to Mutual Funds is now available. Order a copy at 25% off at http://www.buildingwealth.ca/bookstore/productdetail.cfm?product_id=310