The Independent Adviser for Vanguard Investors
•
September 2014
•
5
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Why Bother?
This leads to the obvious question of
why one would bother owning a money
market fund at all.
As I’ve said many times in the past,
I keep a substantial amount of my own
cash in
New York Tax-Exempt Money
Market
. Here’s why: Even if I’m barely
earning any interest and I know I’m not
going to keep up with inflation, I always
want to have a Vanguard money fund as
a repository for “rainy day” money, as
well as a conduit for my other investing
activities. Notice I do not view this as an
investment, but as a practical and useful
asset-management tool.
First, every investor should have an
emergency fund. Life happens! Some
events—like an unexpected medical
expense, or a “downsizing” at work,
or a suddenly leaking roof—don’t
AS I HINT ON PAGE 6, there are times when short-term bond funds make
sense as a substitute for money markets. Remember, a money market
fund is a money management tool for your immediate (within the next 12
months) cash needs. A short-term bond fund can work as a vehicle for
cash that you won’t need for two or three years. The idea is to earn a bet-
ter return without taking on too much additional risk of capital loss.
I have long been a big proponent of this strategy—well before money
market yields hit bottom. But anytime we are in a position to get more
return, it’s important to keep in mind that there is a greater potential for
loss.
Let’s start with the risk, because if you can’t live with the risks, you
shouldn’t reach for extra potential returns. While I’m not aiming to
take on lots of risk in recommending a short-term bond fund, the credit
market freeze in 2008 put all types of funds, short-term bond and money
markets included, to the test. With the crisis several years behind us, we
know that Vanguard’s funds have been battle-tested and all survived to
fight another day. And as long as you didn’t need that money and stuck
with your short-term bond position—remember, this is for cash you don’t
need immediately—any losses were short-lived.
For tax-sensitive investors, I recommend extending out beyond a
money market with
Short-Term Tax-Exempt
, which I liken to a money
fund on steroids. I have used this one myself. Going back nearly 20
years, the worst three-month loss for the fund was just 0.5%, as the
table to the right indicates. That’s something I can live with.
If taxes are not a concern, I’ve always recommended
Short-Term
Investment-Grade
. That advice proved to be terrific until the credit cri-
sis of 2008, when Short-Term Investment-Grade suffered huge short-term
losses as credit markets locked up. The depth of the drawdown—Short-
Term Investment-Grade lost 6.8% in three months—was greater than I
had expected. Before the credit crisis, the worst three-month loss in the
fund was about 2.2%. Even though the loss was recovered quickly, I can
tell you that those few months were nerve-racking.
This is why I emphasize using a short-term bond fund for cash you
don’t need to spend immediately. Even after the 2008 experience, though,
I still have confidence in Short-Term Investment-Grade as an alternative
for cash—particularly in the current low interest-rate environment.
For a broader sense of the risks and rewards involved, in the table to
the right, I’ve applied my rolling returns analysis to Vanguard’s money
funds and short-term bond funds, listing the worst three-month, six-month
and 12-month returns over the past nearly 20 years, as well as the best
and average returns over those periods. Short-Term Investment-Grade’s
“worst” is pretty bad, but its “best” returns are also pretty darned good.
That said, I completely understand if you want something a bit calmer.
Any of Vanguard’s other short-term funds would have proven a safer bet
in 2008, and all are solid options.
Another option as a cash substitute is
Short-Term Inflation Protected
Index
. The fund is not yet two years old, so I did not include it in the table
with the other cash substitutes, but with a short maturity profile it is a
viable option for this role—particularly if you are concerned about infla-
tion. This is how Vanguard appears to be using the fund within the
Target
Retirement
series of funds. Note that the fund last paid out a dividend in
December 2013, so you aren’t earning any current income right now.
There is a final alternative for what I’ll call “longer-term” cash that
you may find of interest. Paul Kaplan, former manager of
GNMA
and
Wellesley Income
’s bond portfolio and the now-retired chief of
Wellington Management’s bond shop, told me many years ago that he
considered GNMA a cash substitute. The data both backs Kaplan up
and highlights why this is for your “longer-term” cash. Had I stopped
the analysis in the table below at the end of 2012, the worst six-month
decline for GNMA would have been a drop of 1.8%. However, GNMA is
more sensitive to interest rates than most of the other funds in the table,
and when interest rates rose in 2013, this fund felt more of the pain—
experiencing its largest decline over a six-month period, 3.2%.
Have no doubts: Interest rates will rise, and money markets will pro-
duce some income again, just as short-term bond funds will show some
short-term losses. In the end, it is really up to you how much (potential)
short-term pain you’re willing to suffer for the prospect of longer-term
gains. Just keep in mind that there is no free lunch, and reaching for that
extra return does court some extra risk.
>
Risk and Reward for Money Funds
and Short Substitutes
Rolling Returns Since 12/31/94
3-Month
Short-Term Treasury
Short-Term Federal
Short-Term Invest.-Gr.
Short-Term Bond Index
GNMA
Admiral Treasury MM
Prime Money Market
Tax-Ex. Money Market
Short-Term Tax–Exempt
Limited-Term Tax-Ex.
Worst
-1.3% -1.5% -6.8% -1.8% -3.7% 0.0% 0.0% 0.0% -0.5% -1.6%
Average
1.1% 1.1% 1.2% 1.2% 1.5% 0.7% 0.7% 0.5% 0.7% 0.9%
Best
4.5% 4.3% 6.0% 4.2% 5.6% 1.6% 1.6% 1.0% 2.1% 3.5%
6-Month
Worst
-0.6% -0.9% -6.9% -1.3% -3.2% 0.0% 0.0% 0.0% -0.2% -1.1%
Average
2.2% 2.3% 2.4% 2.4% 3.0% 1.4% 1.5% 1.0% 1.4% 1.8%
Best
7.6% 7.6% 10.4% 8.0% 10.6% 3.1% 3.2% 2.1% 3.5% 5.3%
12-month
Worst
-0.5% -0.7% -5.8% -0.7% -3.4% 0.0% 0.0% 0.0% 0.2% -0.3%
Average
4.3% 4.6% 4.9% 4.7% 5.9% 2.8% 2.9% 2.0% 2.9% 3.6%
Best
12.1% 12.4% 15.7% 12.9% 17.0% 6.1% 6.3% 4.0% 6.1% 8.6%
Short-Term Bonds Lend a Hand
