Individuals and entities can find themselves holding cash for any number of reasons: general savings, specific savings for planned expenditures, asset sales, and more. Most people would agree that they would like to maximize their cash assets, but many people assume that a savings account at a bank is the only way to go. As you will see, there are other ways to maximize your cash assets over the short term. If you are an independent-minded investor, read on to uncover two very attractive options for achieving this end: the premium brokerage account and the direct mutual fund account.
There are two assumptions that should be made plain with regards to this discussion. First, the short-term nature of cash demands a very low risk exposure or, stated in a different manner, a high degree of price certainty. Specifically, this article will not advocate the comparison of checking account funds to longer-term instruments such as equity mutual funds because the value of equity mutual fund shares can often vary on a daily basis. This is not an apt comparison because a return-maximizing investor seeking to conduct an everyday transaction (i.e. buying groceries) must be certain that his or her short-term cash has not been reduced by yesterday's stock market sell-off.
Second, cash-like funds should be accessible in a reasonable time frame without a penalty. Thus, certificates of deposit (CDs) and the like are not a viable option in this regard. Although CDs are generally considered to be short-term investments, they cannot be turned into transactional money without the issuer assessing a penalty that destroys the investor's return. (To learn more about CDs, see Step Up Your Income With A CD Ladder and Are certificates of deposit a kind of bond?)
What is disintermediation?
Before exploring the actual instruments, it is important to understand the differences between financial intermediation and disintermediation.
Anyone with a checking/demand deposit or savings account uses the services of a financial intermediary (a bank). The bank, acting as a "middleman", combines the small deposits of many and goes to the primary and/or secondary security markets to purchase larger denominated short-term interest bearing instruments (i.e. Treasury bills). The bank then promises to pay the depositor a stated interest rate for the funds, subject to periodic adjustment, and collects the difference.
Disintermediation, on the other hand, occurs when the depositor goes directly to the primary or secondary market to purchase short-term interest bearing instruments. The fact that a depositor uses a mutual fund arrangement to accomplish this does not change the fact that this is a direct method of investing. Under the mutual fund arrangement, shareholders collect the market interest rate minus a management fee paid to the mutual fund manager.
There are two important distinctions between using the bank and the direct method. The first difference is the existence of government-sponsored account insurance; banks are part of the Federal Deposit Insurance Corporation (FDIC) system of deposit insurance, while the direct method is subject to the many market risks and is not insured. However, if one establishes a direct account through a brokerage firm, that account may be covered by the Securities Investor Protection Corporation (SIPC), which provides limited protection against investment losses as a result of certain broker-related actions Second, money market funds are regulated under the Investment Company Act of 1940 and are sold by prospectus only. (To read more about this, see Are Your Bank Deposits Insured?)
The Premium Brokerage Account
Most brokers offer several "levels" of brokerage accounts. Virtually every brokerage account comes embedded with a money market mutual fund account. These funds are invested in short-term fixed income securities via mutual funds shares. The underlying instruments used by bank and direct participants are often identical; the difference is that the direct method funnels all of the interest of those underlying securities to the mutual fund shareholder minus a management fee (approximately 50 basis points). This can be a yield of several hundred basis points compared to what banks may offer on similar accounts. Factors affecting the realized difference in interest rates include the bank's desire to attract funds and the prevailing market environment. (To learn more about brokerage accounts, read Picking Your First Broker, 10 Things To Consider Before Selecting An Online Broker and Understanding Dishonest Broker Tactics.)
Both regular and premium accounts have the ability to hold marketable securities and money market mutual fund shares, but premium brokerage accounts stand apart from regular brokerage accounts primarily in terms of access to funds and additional features. Premium accounts may offer check-writing capabilities and debit card access to funds, allowing continuous access to funds as needed. This maximizes interest earned when funds are not needed. Furthermore, it is possible that the premium account arrangement could simplify the investor's monthly statement routine through elimination and consolidation of accounts.
The Direct Mutual Fund Account
The second option for maximizing interest is the use of a fund-direct money-market mutual fund account. Most mutual fund companies offer and manage a money market mutual fund. Again, this is a direct investment in money market instruments by way of mutual fund shares. Oftentimes, both the interest rate received and the management fee charged on these funds will be approximately equal to those earned on the premium account established at a brokerage house.
The key distinction between these two options is the availability of the funds and the mechanics of moving funds. Fund-direct mutual fund account funds are not available on demand, but funds are available to be sold and transferred on non-holiday business days throughout the year. Generally, mutual fund shares require a one business day settlement period. Once settled, the funds can be dispersed via a physical check or automated clearing house (ACH) deposit directly into a checking or savings account. This is still a very attractive option considering the interest rate earned and the expectation of having liquid funds available within a few days.
There are nuances between the offerings of competing companies for both of the above products. With that in mind, an investor should be prepared to critically view the benefits and drawbacks to any one firm's offering with regards to the premium brokerage account. Investors should also pay attention to the return generated on money market funds (tax-free interest funds may also be available); specifically, the net expected performance must exceed that of your next best option. The investor should analyze his or her expected balance level in relation to savings & loans (S&Ls), community banks, credit unions, online banks and newly chartered banks. Some of these institutions may be in your neighborhood.
Fees must be examined. Annual fees could be as much as $200 per year, not inclusive of trading costs. Other less obvious fees issues include ATM fee policies and other explicit or implicit fees. (Find out more about banking in The Ins And Outs Of Bank Fees, The Evolution Of Banking and Choose To Beat The Bank.)
In order to avoid buyer's remorse, an investor should review other features of the account. Items such as compatibility with existing personal financial management software, online capabilities, etc. should also be researched before making the switch.
The investment of cash should not be an afterthought in a financial plan. An investor's ability to capture additional interest can make a significant difference in a portfolio's risk-adjusted returns, especially for a conservative investor.
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