Money Funds Stumble In Dance With Derivatives

WHEN it comes to buying into a money-market mutual fund, a bit of advice is in order: ``buyer beware.''

In September, the $82 million Community Bankers United States Government Money Market Fund collapsed. Investors were left with about 94 cents on the dollar, and protracted litigation from account shareholders is expected.

This was the first time in a decade that a money-market fund had gone belly up. Ironically, the Denver-based fund had been a consistent top performer in achieving high yields.

But it was precisely the fund's high yields that should have alerted investors to risk, experts say. Fund managers were investing part of the fund's assets in high-risk derivatives. Derivatives are exotic, complex financial securities, such as ``inverse floaters'' and ``leveraged floaters,'' whose value is ``derived'' from an underlying asset or index. The Community Bankers fund was geared to institutional customers - some 94 banks and bank-holding companies. The question here is whether retail funds small investors patronize are equally at risk.

``With so many funds out there now, there's the possibility that Community Bankers is far from an exception,'' says Don Phillips, publisher of Morningstar Mutual Funds, a Chicago-based market report. There have been between 10 and 20 other money-market mutual funds that fund sponsors have had to bail out this year after the funds lost money on derivatives, Mr. Phillips says. In the case of the bailouts, the fund's net asset values would have dropped below $1 per share had there not been an infusion of cash from the parent company.

``If a fund's yield is markedly higher than its peers, but the fund's expenses are the same, then there is a strong likelihood'' that the fund is taking special risks through using derivatives, says Phillips.

Few Americans are familiar with the brouhaha over the Community Bankers fund, financial experts say. And with interest rates rising, money continues to pour into money-market mutual funds, says John Collins, a spokesman for the Investment Company Institute (ICI), a Washington-based trade group.

At the end of October, assets in money funds totaled a record $586 billion, up from $575 billion at the end of September, Mr. Collins says. The ICI counts a total of 959 money-market funds; three-quarters of them are taxable funds, the type of funds that had problems earlier this year.

Ironically, the collapse of the Community Bankers fund came despite an effort by both the Securities and Exchange Commission (SEC) and the ICI to take precautions to avoid just such an occurrence. At the end of June, following a request for action from the ICI, the SEC issued a clarification of existing rules regarding use of derivatives. The SEC asked the ICI to distribute the clarification to its members, which it did, Collins says.

Specifically, the SEC clarified Rule 2a-7, established in 1991, which sets restrictions on the kinds of securities held by taxable money funds. The clarification said that five specific types of derivatives were deemed ``inappropriate,'' and funds should cease from using them in an ``orderly way.''

All five derivatives have adjustable rate characteristics that would lag changes in interest rates and could, thus, lead to financial losses.

``The likelihood of a retail fund collapsing is negligible,'' says Walter Frank, chief economist of The Money Fund Report, published by IBC/Donoghue Inc., in Ashland, Mass. Still, ``for peace of mind,'' an investor might wish to buy only into a money fund that is part of an established family of funds or that has a prominent financial house behind it, Mr. Frank says. If the fund did incur losses linked to derivatives, the parent company would presumably bail out the fund, Frank says.

WHILE derivatives have incurred a nasty reputation following the well-publicized losses by a number of corporations that have invested in them, the use of derivatives is long-established in financial circles, says P. Norman Roy, president of the Financial Executives Institute (FEI), a trade group in Morristown, N.J.

While many money funds use derivatives to enhance yields, many corporations use derivatives to limit risk - that is, to prevent losses in corporate assets invested in diverse securities.

Currently, trillions of dollars in the US are invested in derivatives. New disclosure requirements for corporate financial executives regarding use of derivatives are expected to be issued sometime soon by the SEC.