When Alan Greenspan began slashing the federal funds rate after the Sept. 11 terrorist attacks, he dealt a blow to money-market funds. Yields on money dropped along with other short-term rates. That sent financial advisors in search of better returns on cash. Many advisors turned to FDIC-insured bank deposits, and the assets in money funds dropped from $2.2 trillion in 2001 to $1.8 trillion in 2004. Now the tide is beginning to turn back to money-market funds. But should advisors wade back into money markets or keep clients in insured bank deposits?
The average rate on money funds has climbed from a meager 0.54 percent in June 2004 to 3.86 percent in February 2006, according to iMoneyNet, a money-market mutual funds information provider. The rise has helped make money funds more competitive with bank deposits. Money-fund assets have climbed back above $1.9 trillion. “As rates increase, clients are paying more attention to their cash and giving money funds a look,” says John Overholtzer, president of Investors Resources Group, an independent broker/dealer in Vacaville, Calif., that clears trades through Bear Stearns.
A decade ago, the major brokers all offered money funds as the default option in their sweep accounts. Then in 1997, The Reserve Funds, a cash-management firm, invented a new sweep platform that provided FDIC insurance. Major brokers followed, buying bank charters or cooperating with banks to offer the insured accounts. Big participants soon included Merrill Lynch, Smith Barney and Schwab.
The new insured accounts had some clear advantages. The insurance appealed to conservative investors who had long kept their money in banks. In addition, the insured brokerage accounts could be tailored, enabling financial advisors to offer their best customers higher rates. In contrast, money markets had to pay each investor an amount based on the yields of the instruments in the portfolio. For brokers, the insured accounts could be much more profitable. Also, with a money market, the broker could only charge a management fee of about 50 basis points. But with an insured account, the brokerage could earn the spread between the cost of funds and what the client earned. In some cases, the spread could be two percentage points or more.
Yield and Safety
With so much to gain, brokers shifted rapidly to insured deposits. From 2000 to 2004, $250 billion moved from money funds to brokerage FDIC accounts. Today about $500 billion is in insured brokerage accounts, according to iMoneyNet. Merrill Lynch has emerged as a leader. In 2000, Merrill raised the yield on FDIC accounts above 6 percent, higher than what the company's money fund paid. Cash in Merrill's FDIC accounts ballooned from less than $10 billion in 2000 to more than $60 billion in 2004. “Merrill understood that the insured accounts could reach clients who had been wary of keeping cash at brokers in the past,” says Eric Lansky, managing director of The Reserve Funds.
But now that yields are rising on money funds, the case for insured accounts is less clear. Yields on insured brokerage accounts are all over the map, according to Informa Research Services. On Feb. 5, Smith Barney's insured account yielded 4.10 percent, better than the average money market. At UBS, clients with less than $100,000 in their accounts earned 1.11 percent, while those with $2 million received 3.84 percent. “Is the retail investor better off in a money market or an insured account? The jury is still out,” says Peter Crane, vice president of iMoneyNet.
Less — With More
Brokers argue that even when FDIC accounts offer lower yields, they still compensate by providing more services — including check writing and debit cards — that money-market accounts don't necessarily offer.
Whether or not the FDIC accounts yield more than the top money markets, the insured programs can be powerful marketing tools for financial advisors, says The Reserve Funds' Lansky, whose firm offers both money-market and insured accounts. Lansky says that many clients still insist on keeping cash in bank deposit and checking accounts where they earn tiny yields. “Brokers should point out that they can provide the same services as the bank — and give a much greater yield than the bank is offering,” Lansky says.
One big advantage brokerage accounts can offer is to provide insurance on bigger deposits. At a conventional bank, the FDIC insurance only covers the first $100,000 in an account. That causes some customers to run all over town, opening accounts at several banks. But brokers are able to provide more than $100,000 in coverage on one account. The brokers accomplish this by developing relations with several banks. Merrill owns two bank charters. The broker can split an account in half and assign some cash to each bank. The client is not necessarily aware of the mechanics, but sees that he receives $200,000 in insurance. The Reserve Funds has agreements with many banks and offers a customer up to $1 million insurance on each account.
Instead of providing clients one cash option, Lansky suggests that brokers should consider offering some flexibility. Checking and sweep accounts may rely on relatively low-yielding insured accounts. For money that is being parked for six months or longer, clients may elect to use an enhanced money fund that will yield a bit more and provide fewer services. Finally long-term cash holdings may get higher yields by being stored in such instruments as institutional money funds, certificates of deposit or guaranteed investment contracts. “Brokers should be thinking as total wealth managers and finding the best vehicles for cash holdings,” Lansky says.
Investors Resources' Overholtzer aims to offer clients the choices that best suit their needs and temperaments. His platform enables clients to choose funds or insured accounts. Many clients insist on having FDIC coverage for sweep accounts. “It's important to help clients feel secure, even if they can earn a higher yield somewhere else,” he says.
Many of his clients live in California, and they prefer tax-exempt money funds that avoid state taxes. “Some people hate to pay taxes and they want a tax-exempt fund — whether or not it offers a clear advantage over a taxable account,” says Overholtzer.
If short-term rates continue rising, clients will be focusing more on how their cash is being employed. The increased attention will pressure advisors to look for creative solutions that will generate extra pennies from cash holdings
Best in the Bank Or in the (Money) Market?
The yields of FDIC-insured brokerage deposits are all over the map. Money-market funds yield more that all but Smith Barney's bank.
|Annual Percentage Yield
|ONE Financial Account Insured
|less than $5,000
|Schwab One Account
|$1 to $99,999
$100,000 to $500,000
More than $500,000
|Banking Advantage Money Market
|Less than $100,000
$100,000 to $1 million
$1 million to $10 million
|Basic-Bank Deposit Program
|Bank Deposit Account
|less than $100,000
$100,000 to $250,000
$250,000 to $500,000
$500,000 to $1 million
|Ave Money Market Fund
|Source: Informa Research Services. Yields on Feb. 5, 2006.