Last week, the Wall Street Journal published an article noting that Money Market Fund balances have rose to record levels – over $3 trillion (a staggering total that does not include several trillion more held by institutional investors like mutual funds). A client asked about the article and more specifically, what is the problem with high cash balances?

What’s behind this record “cash stash?” It’s a combination of things – investor behavior, fear about AI mania, and of course, our favorite topic – interest rates.

As the US economy emerged from the COVID era, the Federal Reserve pushed the Fed Fund rates higher and higher to combat inflation. The result was 5%+ rates on cash balances – what investor would turn a blind eye to that? High rates on cash plus record levels of cash (from COVID stimulus programs and market returns) started the money market party and it hasn’t slowed down yet.

Ever since, Fed Funds rates have declined somewhat but remain somewhat elevated on a historical basis, resulting in available yields of 3.5% for money market mutual funds. For an investor class that was used to zero returns on cash, this 3%+ yield feels like a gift. The absolute rate is attractive enough – but it is even attractive on a relative basis. Until recently (due to the Middle East conflict and renewed inflation fears), the yield available on cash has not been all that much lower than the yield available on low risk, longer-duration fixed income like the 2 and 5 year US treasury. This has changed as of late as yields have backed up (the 2 year is now ~4.2% and the US 10 year is at 4.7%) – but investors don’t seem to care.

Despite the rise in rates, many investors are happy to sit in money market funds. They are a zero duration (ie: don’t decline in value if rates do rise), pay a decent yield, are daily liquid, and don’t appear to present any risk of principal loss as financial markets remain stable. What’s not to love?

Money market funds play a valuable role in portfolios – but don’t forget what asset class they represent. They are cash and cash equivalents – an asset class that is best used for holding known liquidity needs and perhaps a portion of your overall asset allocation to mitigate volatility and/or provide “dry powder” if/when a correction comes in the equity markets. Sadly, that asset class is highly unlikely to help you reach your long-term goals. If you adjust for inflation, money market funds are paying sub 1% real returns..very few of us can compound wealth fast enough at that rate to meet our needs long-term.

It can be tempting to view money market funds as part of your fixed income allocation given their current rates – but they fail one key part of that term – “fixed.” The rates on money market funds are directly tied to Fed Funds rates and if/when the Fed is able to cut rates, the yield on money market funds will also fall in lock-step – without warning. And at the time that occurs, available rates on other assets (like bonds) will also be lower. Money market funds are cash equivalents – they are a very useful tool – but don’t overlook your other asset classes in exchange for one that pays you 3.5% before inflation (for now).

What are investors supposed to do? Start by looking at your overall asset allocation in comparison to your pre-established targets. Your cash balance (including money market funds) may be completely reasonable and in line with the allocation needed to reach your longer-term goals. And it may be even more reasonable if you adjust for known cash needs in 1-2 years you have wisely secured in money market funds (such as RMDs, slated home improvement costs, estimated tax payments, etc). Cash is essential to any investment strategy – so don’t assume you have “too much” – do the calculations to find out.

If you are in fact materially overweight to cash, determine which asset classes are underweight and set a plan to deploy some cash over time to bring things closer in line. Fixed income is an interesting opportunity set now – yes, rates can march higher which will put a dent in your principal values (on a mark to market basis). However, the starting place on the coupons/yields is more than likely able to absorb that duration risk and net you a positive total return. Many fixed income securities/funds are yielding between 4-7% with moderate durations. That’s a useful starting point for fixed income investment. Equities remain an important asset class for longer-term growth but pay attention to price levels and your current allocation (which equities at all time highs, it’s likely you may already be maxed out in this bucket).

Again, cash and/or money market funds are very useful and it’s nice that the current market conditions provide a positive rate of return on these balances. However, net of current inflation levels, money market funds are likely not going to be sufficient for the majority of investors to reach their long-term goals, so pay attention to your cash balances and act accordingly.