Pseudo-Money Market
Talking about a higher-yield kind of money-market account, not an account earning interest on pseudo-money.
Here's the deal: let's say you've got a few grand in your savings account which you are saving up for a rainy day, but don't expect to need immediately.
Right now, your options are:
Put it into a Money Market account at a bank or brokerage. This gets you almost no interest, but you can take the money out any time you want with extremely low risk. Right now, the Money Market account is paying between a quarter and a half percent at most banks.
Put it into a short-term CD or saving bond. This gets you a lot more interest, but your money is locked up until the CD or savings bond matures. Right now, a six-month Treasury bond is paying around one percent, and a two-year bond is paying around two percent. A five-year bond is paying around 3.5%, but of course the money is locked up for five years. The risk of losing money, however, is extremely low.
Put it into a short-term bond fund. This gets you almost the same interest as the short-term bond, and you can take your money out any time. However, there is a risk that you may lose some money, as the value of the fund can vary when interest rates change (interest rates go up, value of the fund goes down). Right now, this risk is especially pronounced, since we're in an environment where short-term interest rates are more likely to go up than down.
The tradeoff is this: You can have a higher interest rate, immediate access to your money, or extremely low risk, but not all three.
I'm proposing a fourth option, one which trades a small amount of access to your money for a higher interest rate, and preserves the extremely low risk.
The reason why a Money Market account pays so little interest is that the funds have to be managed as though every investor might withdraw his or her money tomorrow. Of course that never happens, and the flow of money is usually predictable, but that limitation forces the fund manager into the most liquid possible investments. In other words, stuff which matures very quickly (three months or less) and can be sold on the open market at any time.
Can You Do Pseudo?
But let's suppose the investor is willing to live with one limitation: that there is a small chance that withdrawals may be delayed. Let's suppose there is a 1% chance that a withdrawal will be delayed, usually by a day or two. In exchange, the investor gets a significantly higher interest rate.
That means two things: First, the Pseudo-Money Market account isn't quite like cash anymore, but it is still pretty darn close for most people.
Second, the money manager is now free to invest in stuff which isn't as liquid and short-term, because he doesn't need to plan for everyone in the fund taking all their money out on the same day. This lets the manager move to investments which pay a significantly higher rate of return: maybe even more than a one-year or two-year bond (depending on the money flow of the fund).
What really makes this work is the statistics of large numbers. On any given day, for a Money Market fund, people both deposit and withdrawal money, and the fund has to be able to accept both. On some days, there may be more deposits than withdrawals, which isn't usually a problem. Other days, there may be more withdrawals than deposits, so the fund has to sell assets to meet the withdrawals. On average, over time, the withdrawals and deposits pretty much match each other.
But big banks and brokerages have a lot of knowledge about how investors behave over time. They know, for example, that on average, a certain percentage of the money deposited is likely to be taken out within two months. On average, some percentage of the money is likely to be left in the account for more than five years.
So, since the fund manager isn't limited to shorter-term investments, he can fold in the higher-yielding, longer-term investments to improve the overall return. In the unlikely event that there are more withdrawals than anticipated, the manager has the ability to delay paying some of them, to avoid having to sell longer-term securities at a loss. This guarantees the fund's value over time.
In the worst-case scenario, if people start fleeing the fund, something even more interesting happens. In this scenario, as the fund shrinks, the shorter-term (lower yielding) investments get sold/mature first. As a result, the fund's yield automatically goes up. This attracts new investors, providing the deposits to pay the existing investors, and the capital to ensure the stability of the fund. In no event is the fund itself at risk, since the manager can choose to pay the withdrawals only as investments mature.
Are You A Finance Weenie? This Is For You
Finance geeks (and I consider myself one) might argue that what I've described is nothing new. It is essentially an intermediate-term bond fund, possibly grafted onto a Money Market account.
But there is one essential difference.
The delayed-withdrawal feature allows the fund company to guarantee that the fund will never drop below par--that is, that the fund will never lose money. No traditional intermediate-term bond fund can make that claim. It might be an unimportant difference to an economics professor, but the guarantee that you won't lose money is an important marketing point.
It essentially allows a bond fund to be marketed as a higher yielding form of Money Market fund. And since a lot of cash gets placed into Money Market funds essentially by default, this could provide a lucrative way for banks and brokerages to attract new deposits through a higher yielding product.