Money market funds seem to defy gravity. They pay investors less interest but are becoming increasingly popular.
When given a choice, people usually want more for their money, not less. But since the Federal Reserve began cutting short-term interest rates more than a year ago, investors have poured hundreds of billions of dollars more into these funds.
This may seem strange, but there are good reasons for it. Thanks to a combination of convenience, good returns and favorable comparisons with alternatives, money market funds are expected to continue attracting huge amounts of money even as the Fed announced Wednesday that it will cut short-term interest rates by a quarter of a percentage point.
According to Crane Data, an independent financial research firm, large money market funds pay annual interest rates of more than 4 percent. Within the next few weeks, these funds will almost certainly offer about a quarter of a percentage point less. But Peter G. Crane, one of the founders of Crane Data, is quite confident that their appeal will continue.
“I expect about $100 billion to flow into money market funds every month for the rest of the year,” he said in an interview. “The funds are expected to reach $8 trillion in assets by the end of this calendar year,” he said, from around $7.8 trillion currently. “That’s very likely to happen even if interest rates go down.”
Why the continued popularity?
Basically, it's because money market funds are still a good deal, even if they no longer pay more than 5 percent interest, as many of the largest funds did last year.
The return
At certain times, money market funds have been an effective replacement for bonds and investment-grade bond funds, especially if you were looking for a stable and safe place to store cash. We are living through one of these times.
Based on calculations conducted at my request by Jeffrey Ptak, managing director of Morningstar Research Services, returns on money market funds — roughly equivalent to those on Treasury bonds — exceeded returns on investment-grade bond funds in both the last five years and the 10 years ending in September.
That's because bond funds lost value as inflation and interest rates rose sharply in 2022. (Bond prices and interest rates or yields move in opposite directions, and rising yields always affect the value of bonds and bond funds.) I recently wrote about the increased volatility of bond funds in recent years.
In contrast, short-term fixed income instruments such as money market funds or Treasury bills (which expire or “roll over” within a few weeks and can be replaced by higher yielding securities) are excellent under such conditions.
These two distinct effects – depreciation of bonds and higher returns for money market funds – have occurred simultaneously in recent years and weighed on many portfolios.
Here are the five-year annualized returns through September:
And here's how these asset classes performed in terms of annualized returns over the decade to September.
Money market funds outperformed bonds in both periods. Bond funds have lost value over five years. Money market funds posted steady gains.
However, don't get too excited.
First, money market funds underperformed the S&P 500 by double digits over both five and 10 years. They are liquid and convenient places to store cash, but they are not great long-term investments.
Second, while stocks and bonds – which I hold in diversified, low-cost index funds – are often viewed as integral parts of a traditional investment portfolio, money market funds are different. They are valued for their convenience, but they have underperformed bonds over longer periods of time, and I expect that underperformance to happen again.
Recent history
Over the past 25 years – particularly after the 2007-2008 financial crisis and at the start of the Covid pandemic – there have been long periods in which the Fed cut short-term interest rates to near zero. Back then, money market funds followed the Fed's lead and paid investors next to nothing. During those years, I kept my money in government-insured bank accounts and only reinvested it in money market funds when they started offering reasonably attractive interest rates.
For example, in June 2022, when inflation peaked at 9.1 percent, large money market funds paid just 0.6 percent interest. Still, this was a big jump from virtually zero, which is the money market return for more than two years. At the time, I pointed out that while we were not returning to the early 1980s – when money market interest rates rose above 15 percent in line with inflation – it was very likely that money market funds would soon become extremely popular again.
At the beginning of 2023, their returns were over 4 percent. Interest rates are starting to fall, but the rising popularity of funds isn't over yet. We are seeing a gradual return to their traditional place as a useful part of an investor's toolbox. They aren't heavily marketed because the better funds have extremely low expense ratios — the Vanguard Cash Reserves Federal Money Market Fund's Admiral Shares fund charges just 0.1 percent — so they don't generate much of a profit for their providers.
But the funds are still quietly pushing through. Mr. Crane expects they will continue to grow until their yield falls below 3 percent. “This level seems to be an important level,” he said. It will likely make people think about whether it's time to put their money elsewhere. However, the Federal Reserve currently assumes that its key interest rate will not fall below 3.1 percent in the foreseeable future.
However, that could change suddenly if the economy falls into a serious crisis and the Fed has to radically cut interest rates. The last time this happened, in early 2020, large companies continued to use money market funds as yields fell near zero, but many retail investors abandoned the funds.
Banks offer insurance from the Federal Deposit Insurance Corporation, which money market funds do not. While the funds have generally weathered the financial crises of the last few decades well, there have been some problems. In two brief cases, for example, money market funds were unable to pay 100 cents for every dollar invested in them – they “broke the dollar,” in Wall Street parlance. Ultimately, however, there were no significant losses.
If money market funds were to be deprived of their superior returns, they would lose a large part of their attractiveness. As short-term interest rates decline, it may make sense for some investors to lock in higher interest rates.
The view
In the immediate future, money market funds are likely to provide real value as returns exceed inflation. The latest consumer price index report showed prices rose 3 percent annually in September. The Fed is trying to balance two goals: curbing inflation while supporting the labor market.
Money market funds would be well positioned if the Fed kept short-term interest rates above 3 percent, but it wouldn't have that luxury. The Trump administration has pressured the central bank to cut interest rates more, threatening the Fed's independence, and investors need to remain flexible.
The stock market is booming but volatile. Nvidia, the leading artificial intelligence infrastructure company, reached a market value of $5 trillion on Wednesday. The value rose by a staggering $1 trillion in just four months.
The more extreme the valuations on the stock market, the more reassuring it is to have a large supply of cash. The still good money market interest rates make holding cash even more pleasant.