After the European Central Bank cut interest rates last week, both JP Morgan and Goldman Sachs announced they were closing some of their european money market funds. With the Fed looking increasingly likely to cut rates, money market investors should start looking at alternative ways to capture yield now.
Interest rates at some major U.S. money market mutual funds have averaged less than 0.10% for the past 3 years. At that rate, $1 million earns just $1,000 a year in interest. It’s hard to believe that savers may soon have to accept even less.
On Saturday’s Investment Masters Roundtable,EugeneGroysman and I discussed an intriguing alternative.Eugeneruns a Marketocracy portfolio that currently has a dividend yield of 13%. Over the past year, many of the stocks in this portfolio have returned more than 13% because they have appreciated as interest rates have fallen. Could this portfolio be a good alternative to a money market fund?
Listen to the discussion:Reserve a seat at the next session.
Ken: I’m not ashamed to admit that I am old enough to remember when money market mutual funds paid double digit interest rates.
Eugene: I wasn’t old enough to remember, but I was alive when that happened.
Ken: I’m shocked at what some of the largest money market funds are yielding these days. Schwab, Vanguard, and Fidelity are all paying between 0.01% and 0.04% a year. There are some places where you can still get 0.10%, but even that is nothing to write home about. At these rates, it doesn’t seem like it’s worth the effort to maintain records and file tax returns on a money market account any more.
Eugene: It’s a horrendous situation for people. With inflation at 2%, they are losing 1.99% of the value of their money each year, albeit safely.
Ken: Of course, safety is the main reason investors keep their money in these funds. With these money market funds, you won’t lose any money, but you can most definitely lose purchasing power.
Eugene: Exactly. The Federal Reserve has said that they are not going to raise interest rates for at least the next 2 years, in fact, they are likely to reduce rates further. If the yields fall any further, you will start to see some of money market funds closing simply because the rates are too low for them to stay in business.
Ken: Lets take a look at some of the stocks you’ve got in your high yield portfolio. Tell us what these companies do and how you selected them?
Eugene: All of these companies invest in mortgage backed securities that are one way or another guaranteed by an agency of the U.S. government.
Ken: This would be the same U.S. government that guarantees the Treasury bills and bonds in which money market funds invest?
Eugene: That’s right, the securities these companies buy are guaranteed by the U.S. government, just like the securities that money market funds buy. The difference is that these companies are buying longer term securities whereas money market funds are typically very short term.
Ken: If you look at the column in the table for the 1 year returns, it looks like these four companies averaged a total return of about 15% last year. So, $1 million would have earned $150,000 or 150 times the average money market rate of return for last year which was about 0.10%.
Eugene: Right, you have to keep in mind, however, that there is inherent risk in buying securities in the stock market. However, I chose stocks that not only have double digit yields, but also had low volatility compared to the market. The entire portfolio has an average beta of about .30 so it is significantly less risky than the S&P 500. However, the average weighted yield on the portfolio is just over 13%. The combination of high yield and low volatility is what I looked for in stocks I’ve put in this portfolio.
Ken: If we are getting 150x the money market return, what are the extra risk? When I look at these companies, I think the main risk is if interest rates start rising. Have you considered that possibility?
Eugene: You have to keep in mind that no one is talking about raising rates at this time. The E.U. just cut rates. China cut rates. The Fed extended operation TWIST and discussed the possibility of cutting rates further. The disappointing employment report we got on Friday increases the probability that rates are going down, not up.
Ken: It’s hard to believe that there’s room for the Fed to cut rates from here. I can’t see how money market funds are making any money at today’s rates.
Eugene: A lot of money market funds aren’t making money now. Goldman Sachs and JP Morgan just shut down their European money market funds after the ECB cut rates last week.
Ken: And for Goldman and JP Morgan to shut their funds, they must have concluded that rates are going to stay at an unprofitable level for them for a long time – longer than they would be willing to subsidize these funds to keep them alive until interest rates rise.
Eugene: We are coming to the point where a lot of money market funds might start to shut down.
Ken: At some point though interest rates do have to rise. You are not saying that interest rates are going to stay at this level permanently?
Eugene: Eventually, the unemployment rate will fall and the central banks will start raising rates. However, even when you see the unemployment falling significantly, the Fed will be reluctant to raise rates quickly out of fear that it could cause another recession. When rates start rising we may have as much as a year to get out of these stocks before rates are ratcheted up enough to do any real damage. With the economy as weak as it is, it will be at least 2014 before there is talk of higher interest rates.
Ken: We know that these stocks pay a lot more in dividends than you can get from any money market fund. We also know that these stocks are more risky than a market fund. Is the extra reward worth the risk?
Eugene: I think at this point the reward is definitely worth the risk. With the portfolio’s dividend yield at 13% and the beta at .33 even if the market goes down, you stand a very good chance of making more money in these stocks than in a money market fund. For example, if the market drops by 30%, the historical beta implies that this portfolio might lose 10%. But since the dividend yield is 13%, you could still be up at the end of the year, and by a lot more than the money market fund would be.
Ken: Let's look at the risk-reward tradeoff from the perspective of a short term investor. If you think interest rates are going to be flat over the next month, you have a chance right now to earn a whole year’s worth of interest in the next month and maybe even make a capital gain if interest rates fall.
Eugene: That’s right.
Ken: Interest rates will eventually rise and there will be a time when you will have to sell these stocks. These are not stocks you can buy and hold forever. What are you looking at to tell you when to sell?
Eugene: As I mentioned before I don’t think interest rates will rise until there is significant employment growth. The Fed will wait to see month after month after month of employment growth before raising rates so we will have time to make adjustments when the time comes.
Ken: I think this has an exceptional risk-reward tradeoff right now, and it sounds like you have a good strategy for knowing when to get out of these stocks. Would you recommend people take money out of a money market fund to invest in these stocks?
Eugene: It would depend on how much risk an investor willing to take. People who absolutely can’t lose any money should stay in their money market account. But since the risk-reward profile is so favorable, I think most investors should consider putting say 20% of their money market account into stocks like these.
Ken: Thank youEugene.
Reserve a seatat the next Investment Masters Roundtable on Saturday, July 14.
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Disclosure: I am the portfolio manager for mutual and hedge funds advised byMarketocracy Capital Management, an SEC registered investment advisor. Before relying on the opinions expressed in this article, you should assume that Marketocracy, its affiliates, clients, and I have material financial interests in these stocks and may hold or trade them contrary to these opinions when, in our view, market conditions change.
