There are important differences between single state tax-free money funds and general purpose, taxable money funds. Although tax-free money funds are widely held by many investors, they are appropriate for only a very small portion of investors.
This might come as a shock to many investors, but when it comes to money fund investing, taxable is actually a better investment than tax free for a number of reasons.1. HIGHEST QUALITY. Taxable money funds are currently prohibited from investing more than 5 percent of their assets in obligations whose credit quality is rated second-tier or lower. 95 percent of the investments must be in the equivilent of AAA rated paper. Tax-free money funds have no such quality restrictions.
While it is rare to find second tier in taxable money funds, it is rare NOT to find second tier paper in tax-free money funds.
2. ALL THE FACTS. Full disclosure is the rule with taxable money market obligations. The tax-free obligations are largely unregulated, and their disclosure standards are much lower than taxable obligations. Steve Schachat, portfolio manager of Evergreen Tax Exempt Money Market Fund stated, "There are no National regulations controlling how municipalities invest their money. Robert Citron, Orange County (Calif.) Treasurer, for example, invested 42 percent of the county's money in high-risk derivatives."
3. MARKET RISK IS DIFFERENT FROM CREDIT RISK. While many state and local governments are prohibited from investing in risky investments such as derivatives, they are permitted to invest in U.S. government bonds. This is, however, where most of the current market risk resides since we are in a period of rising interest rates.
4. NOT ALWAYS TAX FREE. Many of the higher yielding tax-free money funds invest in obigations whose quasi-tax-exempt interest is not tax-exempt to investors whose income is subject to the alternative minimum tax. Therefore, many tax-free money fund investors received lower yields and bore the additional tax burden of the alternative minimum tax, which eliminated any possible advantage over the safer taxable money fund.
5. NO DIVERSIFICATION. Most importantly, despite their appeal, double and triple income tax-free money funds hold additional risk. Double income tax-free money funds invest in the obligations of a single state and are thus exempt from city taxes, as well. The risk: these funds are limited to the investment quality of the obligations of a single issuer or, at best, only a few issuers.
6. OFTEN ILLIQUID. Compounding this limitation is the lack of full disclosure and the practice of a single buyer or a small number of buyers being the only buyers for many individual issues. As no one else has researched unique risks of the issue, you can see that the lack of a viable secondary market is the result. If you need to sell, who can you sell to if you are the only holder?
This raises both low credit quality (not very high in California these days) and investment illiquidity issues. In the case of a run on a single-state money funds and/
or selling to realize tax losses, this could cause the fund to sell at fire sale prices, hurting both the investors who sold and the investors who remained. "Yields on California tax exempt money market paper have jumped 70 basis points in the last two weeks," says Schachat of Evergreen.
Mutual funds are required to price the portfolio at a fair market value each day. Many single-state tax-free funds' portfolio holdings are seldom traded so it is hard to price the fund fairly each day. If the obligations have never been sold, it is hard to determine the fair market price. Since taxable money funds invest largely in more highly-liquid, high-quality investments (the recent spate of derivative holdings is a rare exemption) they are safer than their tax-free cousins.
PUSH THE NUMBERS. Quite often, when you compare tax-free money funds with taxable money funds, the taxable money funds offer higher after-tax returns in safer investments. Making this point with a passion are the often overlooked 100 percent state and local tax-exempt money funds.
These funds invest solely in U.S. Treasury obligations and short-term obligations of a very short list of U.S. Government Agency obligations whose interest is, by law, exempt from state and local taxes. While not exempt from federal income taxes, their higher returns plus state and local income tax exemption make them the superior investment.