ETF Alternatives to Money Market Funds

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Published September 06, 2012

| Bankrate.com

Investors are heading for the money market fund exits as regulations are tightened and yields are squeezed.

Enter ultrashort-term exchange-traded funds as a go-to liquid alternative. ETFs are traded on a stock exchange, and their prices change throughout the day. These ETFs can aim for higher yields than money market funds since they can invest in a broader basket of securities. Yet, they still invest largely in high-grade corporate bonds and Treasuries.

There are a handful of money market-alternative ETFs to choose from. Their aim is similar to money market funds -- preservation of capital, and they have their pros and cons.

Eric Dutram, an ETF strategist at Zacks Investment Research, sees them as safe, low-risk investments. "Generally, the ETFs invest in very liquid securities, and they have a huge asset base," he says.

Dutram says one money market-alternative ETF is actively managed and doesn't shadow an index like many ETFs do. The fund also has $1.5 billion in assets, and more than 100,000 shares are exchanged every day. The result is a tight bid/ask spread, the difference between the price at which a share is bought and sold.

Tight bid/ask spreads are what you need to look for when buying an ETF, says Tom Lydon, editor of the ETF Trends website.

But that's not the ETF's only advantage. "We can also have broader investments than money market funds," says Jerome Schneider, portfolio manager of PIMCO Enhanced Short Maturity Strategy Fund. "We can take advantage of securities that money markets can't, such as investing in Canadian covered bonds."

Some pluses, some minuses

The push behind money market-equivalent ETFs is the growth in regulation by the Securities and Exchange Commission of money market funds, typically sold by brokerage firms and mutual fund companies.

To lessen risk, the SEC tightened money market fund liquidity and credit quality requirements in 2010. And it also considered switching to floating net asset value pricing where share prices fluctuate much like stocks, but SEC Chairman Mary Schapiro withdrew those reforms after opposition from the commission. If passed, these reforms could have dinged yields and pushed investors into other investment instruments.

With stiffer regulations, money market fund assets have hovered at $2.5 trillion as investors seek higher yields.

"Money markets are in a desperate situation," Lydon says. "And they can't afford to have a run on confidence."

Despite these money market fund woes, money market-equivalent ETFs aren't necessarily right for everyone, says Robert Laura, president of Synergos Financial Group in Howell, Mich.

"These ETFs are best for intermediate-term investing of no longer than three to six months," he says. "Money market funds have lost their luster, though."

Here are some other pros and cons of money market-equivalent ETFs to consider.

What benefits can I expect?

   Portfolios are readily transparent. Money market-alternative ETFs provide a prospectus and mandate for what they can and can't invest in, Lydon says. PIMCO's Schneider says they also post their holdings online. "So you can see the fund's composition and whether it suits you," he says. Conversely, money market funds are only required to post their portfolio holdings online monthly.

   Securities can be diversified. ETFs can invest in a wide range of securities with differing maturities to bump up yields. But be conscious of security duration, Laura says. Funds with shorter-duration securities are less risky, since they won't be clobbered as hard when interest rates eventually rise. These durations are usually listed on ETF sites.

   Actively managed funds can aim for even higher yields. In a low-interest-rate world, actively managed funds can offer higher returns than their passively managed brothers.

On the downside, you'll pay higher fees, and they can weigh down returns. "Still, you're benefiting from fund expertise," Dutram says.

The drawback of ETFs

   Forget about check writing. Unlike money market funds, ETFs typically don't offer check-writing privileges. Instead, you'll need to sell ETF shares for liquidity. "Investors who need immediate liquidity should invest in bank deposits," Schneider says, referring to certificates of deposit, money market funds and other liquid accounts. "There's no one single solution for parking money. Instead, think in tiers of liquidity."
   Principal can be lost. Since ETF shares float and their prices aren't fixed like money market funds, investors can lose principal. "However, it's difficult to lose a lot of money," Laura says. "These money market-alternative ETFs trade in a tight range with only 10 to 15 basis-point dips." A basis point is one-hundredth of 1 percentage point.

And, your original investment also can grow if the share price rises, Laura says.

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