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Market . Here’s why: Even if I’m barely earning any interest and I know I’m not going to keep up with inflation, I always want to have a Vanguard money fund as a repository for “rainy day” money, as well as a conduit for my other investing activities. Notice I do not view this as an

investment, but as a practical and useful asset-management tool. First, every investor should have an emergency fund. Life happens! Some events—like an unexpected medical expense, or a “downsizing” at work, or a suddenly leaking roof—don’t >

Why Bother? This leads to the obvious question of why one would bother owning a money market fund at all. As I’ve said many times in the past, I keep a substantial amount of my own cash in New York Tax-Exempt Money

AS I HINT ON PAGE 6, there are times when short-term bond funds make sense as a substitute for money markets. Remember, a money market fund is a money management tool for your immediate (within the next 12 months) cash needs. A short-term bond fund can work as a vehicle for cash that you won’t need for two or three years. The idea is to earn a bet- ter return without taking on too much additional risk of capital loss. I have long been a big proponent of this strategy—well before money market yields hit bottom. But anytime we are in a position to get more return, it’s important to keep in mind that there is a greater potential for loss. Let’s start with the risk, because if you can’t live with the risks, you shouldn’t reach for extra potential returns. While I’m not aiming to take on lots of risk in recommending a short-term bond fund, the credit market freeze in 2008 put all types of funds, short-term bond and money markets included, to the test. With the crisis several years behind us, we know that Vanguard’s funds have been battle-tested and all survived to fight another day. And as long as you didn’t need that money and stuck with your short-term bond position—remember, this is for cash you don’t need immediately—any losses were short-lived. For tax-sensitive investors, I recommend extending out beyond a money market with Short-Term Tax-Exempt , which I liken to a money fund on steroids. I have used this one myself. Going back nearly 20 years, the worst three-month loss for the fund was just 0.5%, as the table to the right indicates. That’s something I can live with. If taxes are not a concern, I’ve always recommended Short-Term Investment-Grade . That advice proved to be terrific until the credit cri- sis of 2008, when Short-Term Investment-Grade suffered huge short-term losses as credit markets locked up. The depth of the drawdown—Short- Term Investment-Grade lost 6.8% in three months—was greater than I had expected. Before the credit crisis, the worst three-month loss in the fund was about 2.2%. Even though the loss was recovered quickly, I can tell you that those few months were nerve-racking. This is why I emphasize using a short-term bond fund for cash you don’t need to spend immediately. Even after the 2008 experience, though, I still have confidence in Short-Term Investment-Grade as an alternative for cash—particularly in the current low interest-rate environment. For a broader sense of the risks and rewards involved, in the table to the right, I’ve applied my rolling returns analysis to Vanguard’s money funds and short-term bond funds, listing the worst three-month, six-month and 12-month returns over the past nearly 20 years, as well as the best and average returns over those periods. Short-Term Investment-Grade’s “worst” is pretty bad, but its “best” returns are also pretty darned good. That said, I completely understand if you want something a bit calmer. Any of Vanguard’s other short-term funds would have proven a safer bet in 2008, and all are solid options. Short-Term Bonds Lend a Hand

Another option as a cash substitute is Short-Term Inflation Protected Index . The fund is not yet two years old, so I did not include it in the table with the other cash substitutes, but with a short maturity profile it is a viable option for this role—particularly if you are concerned about infla- tion. This is how Vanguard appears to be using the fund within the Target Retirement series of funds. Note that the fund last paid out a dividend in December 2013, so you aren’t earning any current income right now. There is a final alternative for what I’ll call “longer-term” cash that you may find of interest. Paul Kaplan, former manager of GNMA and Wellesley Income ’s bond portfolio and the now-retired chief of Wellington Management’s bond shop, told me many years ago that he considered GNMA a cash substitute. The data both backs Kaplan up and highlights why this is for your “longer-term” cash. Had I stopped the analysis in the table below at the end of 2012, the worst six-month decline for GNMA would have been a drop of 1.8%. However, GNMA is more sensitive to interest rates than most of the other funds in the table, and when interest rates rose in 2013, this fund felt more of the pain— experiencing its largest decline over a six-month period, 3.2%.

Risk and Reward for Money Funds and Short Substitutes Rolling Returns Since 12/31/94

3-Month

Have no doubts: Interest rates will rise, and money markets will pro- duce some income again, just as short-term bond funds will show some short-term losses. In the end, it is really up to you how much (potential) short-term pain you’re willing to suffer for the prospect of longer-term gains. Just keep in mind that there is no free lunch, and reaching for that extra return does court some extra risk. -1.3% -1.5% -6.8% -1.8% -3.7% 0.0% 0.0% 0.0% -0.5% -1.6% Average 1.1% 1.1% 1.2% 1.2% 1.5% 0.7% 0.7% 0.5% 0.7% 0.9% Best 4.5% 4.3% 6.0% 4.2% 5.6% 1.6% 1.6% 1.0% 2.1% 3.5% 6-Month Worst -0.6% -0.9% -6.9% -1.3% -3.2% 0.0% 0.0% 0.0% -0.2% -1.1% Average 2.2% 2.3% 2.4% 2.4% 3.0% 1.4% 1.5% 1.0% 1.4% 1.8% Best 7.6% 7.6% 10.4% 8.0% 10.6% 3.1% 3.2% 2.1% 3.5% 5.3% 12-month Worst -0.5% -0.7% -5.8% -0.7% -3.4% 0.0% 0.0% 0.0% 0.2% -0.3% Average 4.3% 4.6% 4.9% 4.7% 5.9% 2.8% 2.9% 2.0% 2.9% 3.6% Best 12.1% 12.4% 15.7% 12.9% 17.0% 6.1% 6.3% 4.0% 6.1% 8.6% Short-Term Treasury Short-Term Federal Short-Term Invest.-Gr. Short-Term Bond Index GNMA Admiral Treasury MM Prime Money Market Worst

Tax-Ex. Money Market

Short-Term Tax–Exempt

Limited-Term Tax-Ex.

The Independent Adviser for Vanguard Investors • September 2014 • 5

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