Riskier counterparts to money funds seek a wider audience

Oct 31, 2005 @ 12:01 am

By David Hoffman

NEW YORK - More investors may soon gain access to what essentially are higher-risk counterparts to money market funds which traditionally have been open only to institutional and wealthy investors.

Following the lead of Reserve Management Co. Inc. of New York, some financial services companies are considering plans to launch retail versions of so-called enhanced-cash funds. While the funds offer the potential for higher returns, rising interest rates may dampen their appeal.

Like money market funds, enhanced-cash funds strive to maintain a net asset value of $1 per share. But unlike money funds, they're able to invest in longer-duration bonds, which tend to have lower credit ratings. In exchange for taking a higher degree of risk, enhanced-cash funds have the potential to earn higher yields than money market funds - theoretically, at least.

"It's a very hot topic right now," said Joel Friedman, a director with Standard & Poor's of New York. "Some of the conferences that were just money fund conferences have included sessions on enhanced cash."

In August, Reserve Management launched the first shares of an enhanced-cash fund aimed at a broader group of investors. The minimum initial investment in retail shares of the $2 billion Reserve Yield Plus Fund is $1. The minimum for institutional shares is $10 million.

Scant retail interest

Interest from retail investors has been scant, but that's because Reserve Management has only just begun to market the fund to them, a company spokesman said.

While there's no doubt that money managers want to bring enhanced-cash funds to a broader market, now may not be the best time, said Peter Crane, vice president and managing editor at iMoneyNet Inc., a money fund research firm in Westborough, Mass.

With interest rates on the rise, investors may be more inclined to put money in traditional money funds, which will crank out yields as good as or better than those of enhanced-cash funds, he said.

"When money markets [provide higher yields than] enhanced cash, who in their right might would sit in enhanced-cash [funds], which have less liquidity and less safety?" Mr. Crane said.

It's a roadblock, but it's one that a properly managed enhanced-cash fund can deal with, said Patrick Ledford, chief investment officer at Reserve Management.

As long as an enhanced-cash fund takes a balanced approach - if it is invested in a variety of bond sectors, and it hasn't stretched

for yield by investing in longer-

duration bonds - it should still do well, he said.

For example, the Reserve Yield Plus Fund is yielding 0.12 to 0.15 percentage points over the average money fund, Mr. Ledford said. In a normal period, when spreads among bonds aren't so tight, the fund should yield 0.20 to 0.25 percentage points more than traditional money funds, he said.

Nevertheless, some financial advisers aren't impressed.

"I'm not sure that it isn't anything more than a marketing gimmick," said Lewis Altfest, president of L.J. Altfest & Co. Inc., a New York firm with about $340 million under management.

Ultrashort-bond funds are already available to retail investors, he said. While it's true that enhanced-cash funds fill a space between money market and ultrashort-bond funds, it hasn't been proven that such a space needs to be filled, Mr. Altfest said.

It's an attitude that has prevented some money managers from coming out with retail versions of their enhanced-cash funds.

For example, the $387 million Evergreen Enhanced Income Fund, launched in July by Evergreen Investment Management Co. LLC in Boston, is available only to institutional investors, and the company has no plans to go retail with it.

"We're just not seeing the demand," said Dan Flaherty, an Evergreen spokesman.

One explanation is that many investors view enhanced-cash funds as a replacement for money funds - rather than a vehicle to complement them. When investors take that stance, money funds almost always win over enhanced-cash funds.

"I wouldn't have the same comfort level we do now with money funds," said J. Michael Martin, president of Financial Advantage Inc. in Columbia, Md., which manages $185 million. "It's just not as safe."

But enhanced-cash funds are really a separate asset class, Mr. Ledford said. They generate higher yields than money funds but at the same time are less volatile than short-term-bond funds, he said.

"You're starting to see more retail interest in enhanced-cash funds," Mr. Ledford added. "It's not just institutional anymore."

There are other problems with enhanced-cash funds, however, said one fund executive whose firm offers an enhanced-cash strategy via a private-placement vehicle.

SEC scrutiny an issue

Implementing an enhanced-cash strategy in a mutual fund invites scrutiny from the Securities and Exchange Commission, which has taken a dim view of retail funds that promise a stable value, said the executive, who spoke on the condition of anonymity.

Enhanced-cash funds try to maintain a stable income by striving for an net asset value of $1 per share.

While Reserve Management has proven that that won't be an obstacle to bringing the funds out via mutual funds, fund companies need to be careful not to promise to maintain a NAV of $1 per share, and to state clearly that the fund is not a money fund, Mr. Crane said.

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