Protecting your money: Mutual funds and brokerages

This is the second part of a two-part story on safeguarding your investments in a market crisis. Read Part 1: Banks and Insurance.

MUTUAL FUNDS: (including money-market funds): No fund company has joined the growing list of financial institutions reeling from losses or requiring a bailout (at least not yet). But based on emails I’ve gotten recently, some individual investors still wonder whether they could lose any of the money they have invested in a mutual fund if the fund company were to fail.

The short answer is no. The security of the assets you have in a mutual fund has nothing to do with the financial health of the fund company itself.

The reason is that the money you have in a stock, bond or money-market mutual fund is not a part of the fund company’s assets. So it wouldn’t be up for grabs to pay obligations of the fund company.

In fact, the fund company – Fidelity, T. Rowe Price, etc. – owns neither the mutual fund itself, nor the assets in the fund. The fund is a separate legal entity that is owned by the fund shareholders – which would include you, if you’re invested in the fund. The fund company merely has an agreement with the fund to manage its assets and sell the fund’s shares.

What’s more, the fund assets aren’t even held by the fund company. Those assets are held in a custodial account, usually at a bank or trust company. And that bank or trust company doesn’t own the assets either or, for that matter, have access to them other than for what’s necessary for the fund to operate.

And to protect shareholders from the extremely unlikely chance that some rogue fund employee or other person would somehow manage to get at a fund’s assets, federal law requires funds have fidelity bond insurance that covers instances of fraud, embezzlement and the like.

So in the event a mutual fund company failed, the assets of the fund itself – the assets owned by the funds shareholders – would be unaffected by the failure. Either the failing fund firm would transfer the assets to another fund company or the fund’s board of directors would arrange for the transfer. Either way, fund shareholders would have to okay the new arrangement.

Of course, the market value of your mutual funds is a different story. Regardless of the health of the fund company, the value of a fund’s assets is tied to the value of the securities it owns. So if you own, say, 1,000 shares in a Standard & Poor’s 500 index fund that are valued at $10 a share and your fund company were later to go belly up, your 1,000 shares would be secure.

If, in the meantime the S&P 500 index were to drop 25% – which is roughly the loss the S&P 500 has suffered since its peak last October – those shares would be worth $7,500, not the $10,000 you originally paid. But the market’s decline caused that $2,500 loss, not the fund company’s failure.

There’s one area in mutual funds, however, where people have also come to expect protection from market risk. Here, I’m talking about money-market funds.

Although the value of money-market fund shares are not now nor have they ever been guaranteed, fund companies have long attempted to assure that money-market funds maintain a value of $1 per share.

There have been many times, notably over the last year or so, when fund sponsors have stepped in to shore up the value of their money-market funds. But except for one instance in 1994 when a small money-market fund that catered to institutional investors faltered, no money-market fund had “broken the buck.”

Until now. On Tuesday, the net asset value of the $64.8 billion Reserve Primary money-market fund slipped to 97 cents a share. Then, on Thursday Putnam said it was liquidating an institutional money-market fund, as large redemptions raised the possibility that its net asset value could drop below $1.

In the wake of these developments, the Treasury department announced plans to guarantee up to $50 billion for the next year for both institutional and retail money fund investors.

Is it possible we could still see more money funds break the buck? In this market, I suppose almost anything is possible. But I expect this federal backstop will boost investors’ confidence and make it a lot less likely.

Still, I think you should be conservative when choosing a money fund, avoiding those with suspiciously high yields and sticking to funds of large well-known companies that have deep pockets and reputations to protect. You can reduce risk even further by limiting yourself to funds that invest in Treasury securities only.

But if even the small chance of a small loss is too much for you, you can always move your cash to a bank money-market account, in which case you’ll be eligible for the FDIC insurance I described above.

BROKERAGE FIRMS: Given the troubles at Lehman, the sale of Merrill Lynch and rumblings of problems at other investment firms, investors understandably want to know how the assets they hold in brokerage accounts would fare if a broker shuts its doors.

As with a mutual fund firm, the assets you own in a brokerage account – such as stocks, bonds, money-market funds and mutual funds – are segregated from the brokerage firm’s own assets.

So in the event a brokerage firm fails or shuts down its business for other reasons, it’s the firm’s own assets that are responsible for paying the firm’s obligations, not the customer’s assets. Typically, you or the troubled brokerage firm would just transfer your holdings to another brokerage firm where would have access to them.

Sometimes, though, things don’t go smoothly. That’s where SIPC (Securities Investor Protection Corp.) would step in. Created by the Securities Investor Protection Act of 1970, SIPC is not a government agency like the FDIC. Rather, it’s a nonprofit funded by member brokerage firms that operates a fund that as of the end of last year had $1.5 billion in assets.

If a brokerage firm fails or closes for other reasons and customer assets are missing because of fraud or poor recordkeeping, SIPC will cover each customer for up $500,000, which includes up to $100,000 in cash held with the firm.

There are exceptions: SIPC doesn’t cover alternative investments such as commodity futures contracts, foreign currencies, limited partnerships and precious metals.

Remember, though, SIPC isn’t providing protection against market losses or bad investments. Rather, its aim is to replace securities that are missing from customer accounts, up to the limits of its coverage. For more on how SIPC works, you can check out this story by my Money Magazine colleague Joe Light, and you can visit the SIPC Web site.

So if you haven’t done so already, I suggest you go through your various holdings and assess your vulnerability. You may find that your worries are groundless, or at least not as bad as they seem. And if not, well, at least you’ll be able to chart a course on the basis of facts rather than just fear.

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