Money market mutual funds are breathing a sigh of relief as they dodged a bullet in the form of a potential 50 basis point reduction of interest rates by the Federal Reserve at its meeting in late June.

With many market and economy watchers calling for a half-point reduction, the Fed opted to act conservatively, dropping the rate by only 25 basis points, bringing the prime-lending rate to a flat 1%, for now. A larger slice would have caused some major problems in the money market fund industry, a significant portion of which might have had to surrender fees in order to bring a positive return to investors.

"Any cut hurts, but the 25 basis points hurts investors more than it hurts the asset managers and fund complexes," said Peter Crane, vice president of iMoneyNet in Westborough, Mass. Funds are not losing significant amounts of money and are not being forced to wave fees in mass quantity, he said.

The recent slice was the 13th time the Fed had cut interest rates since the beginning of 2001 and the first time this year; the Fed last lowered the rate in November to 1.25%.

At 1%, the rate is now at its lowest in 45 years.

The problem the rate cut causes for money market funds is that it pushes yields down even lower than they already are. Investors' returns are based on the amount left over after the fund's expenses are subtracted. With the rate lowered, some funds expenses now exceed the yield, so some firms have had to slash fees in order to provide any return to the investor. Failing to do so could cause some of these funds to "break the buck," or fall into negative territory.

Crane said that while about 4% of the funds are currently waiving some portion of their fees to counteract low interest rates, that number would increase fourfold to 16% if the interest rate were lowered an additional 25 basis points. "Even the funds that are waiving fees are not losing money. They are cutting fat," he said. Crane estimates the current cut will end up costing the industry about $100 million in reduced fees, mostly coming out of 12b-1 and shareholder services fees.

"The latest cut just makes the situation more urgent and more serious for more funds," said Don Cassidy, a senior analyst with Lipper of New York. "A number of funds are being subsidized by their advisors so they will be able to pay some income. Some of them are dealing with it and riding out the storm, and others are making the decision that they are not prepared to subsidize their money market fund for the long term. So, some are closing or being merged," he said.

So far this year, assets in the funds have held up fairly well. Retail money market funds held $1.035 trillion in assets as of the end of May, a slight drop-off from the $1.069 at the end of 2002, according to data provided by Lipper. Institutional money market funds dropped to $98.4 billion at the end of May, from $1.084 trillion at the close of 2002.

However, returns have been dismal this year, when compared to those over the trailing five years. Retail funds produced a paltry 0.26% cumulative return year-to-date through the end of June, compared to a 2.95% annual return over the last five years. Institutional returns have not been much better, coming in at 0.43% year-to-date and 3.47% over the trailing five years.

"The fact that nobody is exiting the money fund space is telling," Crane said, noting there are 1,750 funds and roughly 190 complexes running them. "Money funds are quite happy the retail investor has stayed put in money market funds. The $2.1 trillion is still there. The real threat is that the investor takes all their money and leaves."

That fear may be a reality. Cassidy said that one theory is that extremely low returns in money market funds are actually helping fuel the economic recovery in the markets overall. He says that investors, unhappy with tiny returns in the funds are moving their money into stocks, by way of equity mutual funds.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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