Forget Money Market Interest Rates - Look for THIS Instead!

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Lots of people think money market interest rates are the best way to evaluate which money market fund they should open an account up at.

This seems obvious. After all, all other things being equal, wouldn't you rather receive an extra 5 or 10% on the same amount of money. More money is better, isn't it?

It is when "all other things" are equal but, unfortunately, in the real world they usually aren't.

Money market interest rates are determined by a combination of the prevailing market interest rates on short term commercial loans.

According to the United States Securities and Exchange Commission, money market funds must keep their weighted average term below 90 days.

High credit quality, commercial loans under 90 days pay only so much interest, and no more. As with many things, heavy competition keeps rates pretty much in line with each other.

If one bank tries to charge more, the business seeking to borrow the money will simply take their business to another bank.

If a business tries to insist on paying a below-market interest rate, the bank will simply deny the loan under those terms.

Therefore, money market fund managers don't have much room to improve their relative performance, to distinquish themselves from their competition.

Money Market Interest Rates Can't Vary Much Within the Law

They have two options, as John C. Bogle (founder of Vanguard Funds) has pointed out:

1. Lower management fees and expenses

2. Increase risk

Number 1 is not a popular choice with many fund managers as individuals or as management companies. They make less money, or must exercise a lot more discipline to make do with less money.

And there's no need, because the majority of Americans don't care two hoots what their money market fund's expense ratio is.

So money market funds are encouraged to take more risk. They have limited scope to do so, but that doesn't stop them. During the financial crisis of September 2008 several money market companies "broke the buck." That is, their net share value went below $1.

Therefore, you can choose between three different types of money market funds.

Compare Money Market Expense Ratios, Not Money Market Interest Rates

Let's say that the prevailing rate for high credit rating, short term commercial loans is 1.0%.

Money Market 1 -- An average, typical fund. They earn the 1%, but reduce pay out by 10% to pay for their expenses. Therefore, shareowners receive 0.9% interest.

Money Market 2 -- They take some extra risks, staying just barely within the laws and regulations. This enables them to earn 1.2%. They reduce this by 10% to pay for their expenses. Therefore, shareowners receive 1.08%. Sounds good - until another disaster strikes and the fund loses money.

Money Market 3 -- They earn the same 1% as Fund 1, but reduce pay out by only 5% to pay for their expenses. Therefore, shareowners receive 0.95%.

It's obvious that, for the risk, Money Market 3 is the best place to park your money. It's no more risky than Fund 1, but earns more money simply because its management keeps expenses as low as possible (some expenses are inevitable).

Fund 2 looks better if you look only at the money market interest rates, but your money is in more danger than you realize.

Next: Bank Money Market Rate -- how and why bank money market rates are different.

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