Weigh short-term choices

NEW YORK – Few investors give much thought to the money they set aside for short-term goals, or dare to hope for much of a return in the current interest rate environment. But depending on your time horizon, you might be able to do better than you think.

For truly short-term goals, such as money you save to cover your annual tax bill or next semester’s tuition, financial planners say your best bet is either a money market deposit account or a money market mutual fund. Although they pay paltry rates of interest, generally between 1 percent and 2 percent, they’ll keep your principal safe and accessible, and returns are likely to improve as the Federal Reserve continues raising interest rates.

Money market deposit accounts offered by banks are insured by the Federal Deposit Insurance Corp. Money market mutual funds are offered by brokerages and mutual fund families, and are not FDIC insured, but are generally very safe because they invest in U.S. Treasuries. Because there’s not a lot of difference between money market mutual funds, expenses are key, so if you go this route, look for one that charges less than 0.5 percent per year.

For sums held for three to five years or longer, there are probably better options. The three-to-six-month emergency cushion that financial planners recommend you save for living expenses if you lose your job presents an interesting conundrum, said Christine Benz, associate director of fund analysis with Morningstar Inc. Conventional wisdom has long been to keep this in cash or cash equivalents, such as the money market, she said.

But if all goes well, you’ll never need this money, which has led some experts to suggest holding it in short-term bond funds. These tend to pay slightly higher yields, Benz said, and while they don’t guarantee your principal will hold absolutely steady, fluctuations are likely to be quite low. Over the last two decades, the steepest drop in short-term bond funds was 3 percent – a palatable risk for many investors in exchange for higher returns.

Ultra-short bond funds typically hold up better in rising-rate environments. Like money market funds, these tend to offer low returns, so expenses are an important consideration. Among analysts’ picks at fund tracker Morningstar Inc. are Fidelity Ultra-Short Bond (FUSFX) and Payden Limited Maturity Fund (PYLMX). Fidelity’s offering, while relatively new, has beaten the average taxable money market fund while keeping volatility in check; the Payden fund is noted for low expenses, a diversified portfolio and a solid track record. And because they rely exclusively on bonds, they’re considered quite conservative.

“I would feel a little nervous … about putting funds you might need in the short-term in equities,” Benz said. “However, if someone has more of a five-year horizon, I think you could argue for having some percentage of the portfolio in equities.”

For money you’re saving for a big item, such as the down payment for a home you plan to buy in three to five years, conservative asset allocation funds might be a good place to collect your cash. These offer exposure to the money market, bonds and equities. Three picks from Morningstar include T. Rowe Price Personal Strategy Income (PRSIX), Vanguard Tax-Managed Balanced (VTMFX) and Vanguard Wellesley Income (VWINX).