SOME, LIKE USAA AND STRONG, HOLD JAPANESE BANK PAPER: BEWARE OF HIDDEN RISKS, TAXES FROM MONEY FUNDS

Searching for a safe place to park part of your clients’ portfolios until the stock market settles down? Money market funds are offering yields fatter than long-term Treasury bonds, but shop carefully: Unless the manager is waiving its fees, it’s usually a tipoff the fund is holding riskier or tax-biting investments — ranging from Japanese bank paper to municipal bonds subject to the alternative minimum tax.

Consider two money funds now being heavily promoted by Strong Capital Management Inc., the feisty Menomonee Falls, Wis., outfit that has built a reputation of swinging for the fences when it comes to fund returns. Its Strong Investors Money Fund and Strong Municipal Money Market Fund, respectively, sport the highest yields among general purpose and tax-free money funds tracked by IBC Financial Data Inc., an Ashland, Mass., research firm. Strong Investors recently yielded 5.68%, vs. 4.99% for the average taxable money fund. Strong Municipal paid out 3.35% vs. an average 2.8% for tax-free money funds.

How do they do it?

In the case of Strong Investors, the company artificially boosts the yield by absorbing the fund’s operating expenses. Of course, capping or waiving fees isn’t new. Back in 1990, Dreyfus Corp. attracted a whopping $9 billion-plus to its Worldwide Dollar fund this way, but much of it left when the company started charging for its services.

Today, 59% of money funds waive at least a portion of their fees — including nine of IBC Financial’s top 10 yielding taxable money funds. Though almost all fee waivers are temporary — Strong recently extended its program to Jan. 1 — they’re a great deal for investors because the fund manager has no need to seek out less liquid or riskier credits to juice up yields.

just like a loss leader

Strong uses its Investors fund just as a grocer promotes a half-price sale on deli meats — to get customers in the door in hopes they’ll be tempted to buy more profitable products.

It limits its red ink on this loss leader by capping individual accounts at $20,000. Based on the funds recent asset total of $66.3 million and 2% operating expense, Strong would give up $1.3 million on an annualized basis.

“It’s an ingenious maneuver,” says IBC managing editor Peter Crane. “Strong can keep the No. 1 spot for the highest-yielding fund, but still keep their costs down.”

But the $2.1 billion Strong Municipal Money Market Fund is another matter. It doesn’t waive any of its 0.64% expense ratio, yet at 3.35% its recent seven-day nominal yield was 20% higher than the average tax-free fund.

Helping boost the fund’s yield are variable-rate demand notes guaranteed by letters of credit from Japanese banks. Also known as variable-rate put bonds, these securities allow holders to sell them back to the issuer at par value at intervals as short as a week.

Many institutional and retail money funds have sold off these securities as the condition of Japan’s banks worsens. About 10% of the Strong Muni Money Market fund’s assets are invested in floating paper backed by Japanese banks, says the portfolio manager, Steven Harrop.

These securities pay at least 50 basis points more than comparable paper backed by double-A rated banks. Mr. Harrop points out that the securities are very short in duration and that the letters of credit only enhance the primary borrower’s payment obligation — like wearing suspenders with a belt. “Those who are shying away from them are more concerned with window dressing than as a credit problem,” he says.

‘A CALCULATED RISK’

Some credit analysts don’t agree. “It’s a calculated risk that those funds are taking; a number of Japanese banks have deteriorated,” says Doug Rivkin, who rates institutional money funds for Moody’s Investors Service Inc. in New York.

While big investors have pressed institutional money funds to pull back from Japanese paper, some retail funds still hold it. Indeed, United Services Automobile Association’s USAA Tax Exempt Money Market Fund, the country’s fourth-highest-yielding muni fund, holds 11% to 12% of its $1.6 billion in Japanese bank-backed paper.

Fund manager Thomas Ramos says his analysts follow the condition of the Japanese banks very closely, but that the interest rate boost is currently worth the risk. “These Japanese banks are like the Citicorps and BankAmericas with their real estate problems of the early 1990s,” he says. But Mr. Ramos and Mr. Harrop (who worked at USAA before joining Strong in 1991) are in a decreasing minority. American Century Investments’ Benham Group in Mountain View, Calif., sold off its last Japanese-backed security in February. “We thought the yield didn’t compensate us enough for the risk,” says Todd Pardula, who manages Benham’s California Municipal Money Market Fund. “What’s an extra 50 basis points if they go insolvent and can’t back their letter of credit?” he asks.

Stealth tax bombshell

Some yield-boosting techniques don’t involve taking credit risks, but they can be just as costly to unwary investors. Many muni funds now hold securities known as AMT paper, whose interest is subject to the alternative minimum tax. (InvestmentNews, Aug. 17). For the growing pool of investors subject to the AMT, taxes on the interest from these securities can quickly eliminate the advantages of munis — not to mention the 0.10% interest premium they offer.

Because it’s difficult to know from year to year whether one is subject to the AMT, financial planner Jean Sinclair of Arcadia Financial in San Diego, which manages $25 million says

“People are better off focusing on funds that have low expense ratios and don’t hold AMT securities.”

Though Strong advertises its Municipal Money Market Fund as the No. 1 Tax-Free Money Fund, 44% of its securities are subject to the AMT. After InvestmentNews pointed out this might be misleading, the company modified the fine print, to note which fund’s income could be subject to the AMT.

Top-yielding money market funds

Annual Minimum %

Assets 7-day expenses initial subject

Taxable funds ($m)* Yield per $100 investment to AMT

Strong Investors Money Fund $66.3 5.68 $0.00a $1,000 NA

Scudder Prem Money Mkt Shares 654.2 5.49 0.28a 25,000 NA

OLDE Premium Plus MM Series 2,345.6 5.46 0.20a 25,000 NA

Kiewit Mutual Fund/MM Portfolio 307.5 5.42 0.20a 10,000 NA

Aon Funds/Money Market Fund 925.1 5.41 0.20a 10,000 NA

Tax-free funds

Strong Municipal MM Fund 2,139.9 3.35 0.63 2,500 44%

ABN Amro Tax-Exempt MM Fund 253.7 3.26 0.34a 2,000 0

Benham Tax-Free MM Fund 519.8 3.25 0.10a 2,500 21

USAA Tax Exempt MM Fund 1,582.5 3.25 0.39 3,000 0

Zurich Tax-Free Money Fund 799.8 3.23 0.35 1,000 20

*As of Aug. 25

a: Net of absorption of expenses by fund sponsor.

NA: Not applicable. Source: IBC Financial Data Inc.