Betting rates will rise and timing purchases

As interest rates approached a record low in 2002, the Dreyfus Corp.'s Patricia A. Larkin found a way to beat most of her 120 competitors by setting up a money market mutual fund to profit from Federal Reserve increases.

Larkin, betting rates would eventually rise, planned to buy investments for the Dreyfus Institutional Cash Advantage Fund maturing close to Federal Open Market Committee meetings, enabling her to roll them into new ones at higher rates.

The manager, faced with a limited selection of securities in which to invest, needed to stand out from her peers to gain a slice of the $2.45 trillion market for short-term funds. Money streamed into the fund a month after the Fed began a campaign of 17 quarter-point increases in its overnight lending rate between banks in June 2004, ballooning to $22 billion last month.

"Anyone you talk to in this industry will go across the street if you're lagging behind for a period of time [by] more than 2 or 3 basis points," Larkin, 46, said in an interview from her office in New York.

The Cash Advantage Fund, designed for institutional investors, returned 5.27 percent in the 12 months ended March 31, beating the 5.19 percent average of its peers, as measured by Crane's Prime Institutional Money Fund Index. The fund ranked 13th of 121 similar funds, and its three-year return of 3.53 percent placed it 12th among 101 rivals.

The $33 billion Fidelity Institutional Money Market Portfolio gained 5.24 percent in the year through March and an average 3.49 percent over three years.

The $30 billion Goldman Sachs Financial Square Prime Obligations Fund rose 5.21 percent over the 12 months and had a three-year return of 3.48 percent.

Dreyfus and Larkin have among the longest records in the money-market-fund industry, said Peter Crane, president of Crane Data L.L.C., of Westborough, Mass., which publishes the Money Fund Intelligence newsletter.

Larkin, who started at Dreyfus in 1981 answering customer calls while attending Fordham University in New York, oversees a total of $100 billion in 35 money market funds. The Institutional Cash Advantage Fund was Dreyfus' first that was set up to benefit from higher Fed rates.

"Money funds are viewed as a commodity type of business," Crane said. "Because the money-fund pool is so gigantic, everyone is trying to buy the same product. If you time the Fed right, you can gain an advantage."

Money market funds, considered among the safest of investments, do not differ dramatically. Designed to preserve every dollar invested by holding their net asset value stable at $1 a share, they invest in highly rated short-term U.S. dollar-denominated debt such as commercial paper or bank certificates of deposit, or CDs.

Besides the commercial paper issued by corporations, a growing segment of the market is short-term debt offered by special-purpose entities backed by pools of high-quality financial assets, known as asset-backed commercial paper.

As of March 15, the Dreyfus Institutional Cash Advantage Fund held a mix of 46 percent commercial paper, including asset-backed instruments; 40 percent foreign-bank obligations; and 9 percent floating-rate notes. The remainder consisted of time deposits and U.S. bank obligations.

The Fidelity Institutional Money Market Portfolio had 13 percent of its assets in commercial paper, 27 percent in CDs, 33 percent in notes, and 25 percent in repurchase agreements at the end of March.

To help maintain the safety of money market funds, at least 95 percent of assets must be in debt with top ratings from two of the following firms: "P-1" by Moody's Investors Service, "A-1" by Standard & Poor's, or "F1" by Fitch Ratings.

Individual securities must have remaining maturities of 13 months or less, and the weighted average maturity must be 90 days or less. Weighted average maturity is the mean term of all investments weighted according to their individual values.

After the Dreyfus fund was set up in June 2002, the Federal Open Market Committee decreased rates further as a bear market in stocks stretched to three years. The Fed reduced the overnight lending rate in June 2003 to 1 percent, the lowest in more than four decades. Money market rates bottomed out at about half a percent.

Equities rebounded and economic growth accelerated in 2003, prompting the Federal Reserve to start raising rates in June 2004. That is when Dreyfus began marketing the fund.

Larkin said she began altering her strategy late last year by purchasing securities with longer maturities after the central bank signaled 11 months ago that it was likely to pause in raising rates.

"Because we thought the Fed was staying neutral, it was time to spend a little more money out on the yield curve to get the best return," Larkin said. "Prior to then, we were really neck and neck with their meetings."

The fund's weighted average maturity was 54 days at the end of February, compared with 29 days a year earlier.

"If I buy six-month securities today and the Fed lowers rates tomorrow, you can't find that yield," Larkin said. And if the Fed holds steady, Larkin would be no worse off, she said.

Fund manager: Patricia A. Larkin.

Assets under management: $22 billion.

Performance: Up 5.27 percent in the last 12 months.

Significant holdings: 46 percent in commercial paper, 40 percent in foreign-bank obligations as of March 15.

Ticker: DDTXX.

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