Money funds that offer insurance: doubtful need and lower yield

Every now and then an investment opportunity comes along that might be described as . . . redundant. That's the word William E. Donoghue, the money market mutual fund expert, uses to describe a new money fund product making its debut this month. While that description may seem a bit strong to the companies offering it, the cost and necessity both seem hard to justify.

This new investment vehicle is an insured money market mutual fund. Its development comes as a result of a need felt by some people for some sort of insurance on their savings, similar to what they get on accounts at a bank or savings-and-loan institution.

''Looking at the market over the last year or so,'' relates William F. Hostler, marketing director at the Vanguard Group, ''we became aware that there was a group of savers and investors who felt money funds were not for them because they lacked FDIC (Federal Deposit Insurance Corporation) insurance.''

So far, only Vanguard and the Travelers Insurance Company have announced insured money funds. Whether they are followed by others will largely depend on the success of these two. If they are successful, it will almost certainly be the result of effective marketing, more than the need for the product.

The insurance will not protect a money fund investor from declining yields. So at a time when money funds are yielding only two or three percentage points more than passbook accounts, a saver who wants insurance would probably be better off in one of the new money market deposit accounts now available from banks and S&Ls, if they can put together the $2,500 minimum deposit. These accounts are averaging about a percentage point more than the money funds.

Beyond that, the question must be asked, just how important is insurance to the safety of a money market mutual fund account?

In the space of about four years before last fall, money funds grew from about $50 billion to more than $230 billion. At the same time, their customer base expanded from sophisticated investors who used the funds as parking places for cash between stock and bond purchases to individuals and families who used the funds as their primary savings account.

In all that time, no one ever lost a penny in a money fund. And although the funds' yields and assets have dropped in recent months, the principal has remained safe. Part of the reason is that the funds are diversified enough that the collapse of any single investment - also unlikely because of the funds' emphasis on quality - would have very little effect on the value of the entire portfolio.

The insurance policies are supposed to guarantee a fund's constant $1-a-share value. In Vanguard's case, the insurance also covers potential loss due to heavy redemptions. This might happen, Mr. Hostler said, if interest rates shot up rapidly and money fund shareholders withdrew large amounts to invest in the money markets themselves. Such a huge withdrawal could lower a fund's asset base enough to affect the $1-a-share value.

The insurance will result in lower yields, Mr. Hostler admits. It could cut about ''35 to 40 basis points'' off the return, so that instead of earning 8 percent, for example, an insured fund might yield 7.6 to 7.65 percent. Other industry observers estimate that the insurance could cost as much as 75 basis points, or three-quarters of a percentage point in yield, because of the conservative investment likely to be demanded by the insurance companies.

Vanguard, for instance, has agreed to buy securities only from corporations and banks approved by the insurance company. Presumably, the insurer will want to protect its investment by approving only the most conservative - and thus lower-yielding - investments.

The minimum investment in the insured Vanguard fund is $1,000, and accounts are covered up to $2 million, compared with the $100,000 offered by the FDIC. The minimum investment at Travelers, where the funds are marketed more to brokers and dealers than the general public, is $10,000.

If you feel better having insurance on your money fund, then the additional peace of mind may be worth it. But unless the money funds go through a radical change in the prudent business practices they have followed so far, insurance seems to be an unnecessary cost.