A money market fund—also known as a money market mutual fund—offers a relatively safe parking spot for your money. They are popular with investors because they are highly liquid, so the money can fund a new investment opportunity.
But what is a money market fund? And how does it work? Let’s take a look.
What is a money market fund?
Money market funds are mutual funds that invest in short-term debt securities such as U.S. Treasury bills, cash, and cash-equivalent securities. They offer a low level of risk and high liquidity.
Don’t confuse a money market fund with a money market account. Money market funds are regulated by the Securities and Exchange Commission (SEC) and invest your money in the stock market.
Money market accounts are a savings account offered by financial institutions such as banks and insured by the Federal Deposit Insurance Corporation (FDIC).
Just like any other investment, money market funds carry the risk of losing value. However, they are considered a safe way to earn a higher interest than savings accounts or money market accounts.
A money market fund can be a popular tool for investors to park their cash before buying stocks or after selling them. They are much less volatile than the stock or bond markets, but their low returns make them a bad long-term investment.
How money market funds work
Money market funds work just like any other mutual fund where investors buy shares. The fund takes the money and buys short-term government or corporate debt such as U.S. Treasury bonds, commercial paper, certificates of deposit (CDs), and so on.
Types of mutual fund investments:
Certificates of deposit (CDs)
: A federally insured savings vehicle with a fixed interest rate and a short-term date of withdrawal
Bankers’ Acceptance
: A short-term commercial bank draft representing a promise of future payment
Commercial paper
: A short-term corporate promissory note representing a pledge of future payment
U.S. Treasury securities
: Short-term U.S. government debt obligations
Repurchase agreements
: A type of short-term borrowing using government securities
Income from money market funds can be taxable or tax-free depending on the type of portfolio. Tax-free portfolios can be exempt from federal and/or state and local taxes.
Money market funds have tried to maintain a net asset value (NAV) of $1 per share. Investors receive the difference between the NAV share price and portfolio earnings in the form of dividends.
The NAV rule ensures that investors get regular payments although they are not guaranteed to be the same each time. There is also no guarantee that the mutual fund can maintain the share price.
If the fund fails to maintain the $1 share price (called “breaking the buck”), it can be liquidated by regulators. This has only happened twice so far: once in 1994 with the Community Bankers U.S. Government Money Market fund and once in 2008 with the Reserve Primary Money Fund.
These failures resulted in new rules issued by the SEC to provide more stability and prevent similar issues in the future.
Types of money market funds
There are three main types of money market funds: prime (also known as general purpose), government (including U.S. Treasury), and tax-exempt (also known as municipal). Prime and tax-exempt mutual funds are further divided into retail or institutional.
Regardless of their classification, all money market funds must comply with regulatory requirements concerning the diversification of the fund’s investment, the type of investments it holds and their liquidity and maturity.
Types of money market funds:
Prime (general purpose)
: This type of fund invests in corporate notes, commercial paper, CDs, debt issued by U.S. government agencies, and so on.
Government:
This type of money market fund invests at least 99.5 percent of total assets in cash, government securities, and repurchase agreements. This can include U.S. Treasury securities and repurchase agreements for them.
Tax-exempt (municipal)
: This type of fund comprises municipal securities exempt from federal (and sometimes state) income tax. As a result, earnings from tax-exempt funds are also tax-exempt.
Some money market funds are targeted toward individual investors, while others aim to attract institutional money. Those targeted toward individuals are known as retail money market funds, while those targeted toward institutions are known as institutional money market funds.
Retail funds seek to maintain a stable $1 share value or NAV but may charge certain fees or suspend your ability to sell shares depending on market conditions.
Institutional funds don’t have to maintain a stable $1 share value but can use a floating NAV, which allows for fluctuations. These funds may also charge certain fees and suspend the ability to sell shares.
Both individual and institutional investors can buy government money market funds. They don’t charge fees, suspend your ability to sell shares, and are not subject to a floating NAV.
Advantages and disadvantages of money market funds
There are both advantages and disadvantages to investing in money market funds. Sometimes, they can be the right choice and offer a way to protect and grow your money.
However, they have downsides that can increase your risk and your opportunity costs.
Advantages of money market funds
Money market funds are one of several options for investors looking to park their cash in the short term. Other options include money market accounts, high-interest savings accounts, and so on.
The main reason for putting your money in a money market fund is to find a low-risk (but low-return) investment. Sometimes, they also offer tax-exempt returns.
They have several advantages over other investment options:
Low risk
: Money market funds offer low volatility and therefore low risk. They are a relatively safe investment where you can park your cash temporarily.
No fees
: Money market funds don’t charge entry or exit fees (or loads).
High liquidity
: Investments within money market funds are highly liquid so you can get them out within a few business days. Many also allow investors to write checks.
Better returns than bank accounts
: Most money market funds earn more than high-interest savings accounts. Sometimes, such as with municipal funds, the earnings are also tax-exempt.
Disadvantages of money market funds
While there are advantages to money market funds, investors should also consider the downsides. They can be a good option in certain situations but may not work well in others.
Disadvantages of money market funds:
Variable rates
: Unlike traditional savings accounts, there is no guarantee on the rate of return for money market funds. This means you don’t know how much you will earn from month-to-month.
No capital appreciation
: Because of the conservative nature of money market funds, investors don’t get capital appreciation. This is a low-risk but also low-return investment.
Not FDIC-insured
: Since money market funds are a type of mutual fund, they are not insured by the FDIC. They are a security and thus regulated by the SEC. There is still a risk that you can lose your money without the backing of a government entity.
Opportunity cost:
Money market funds generally offer low returns over the long term unlike riskier investments such as stocks. Over the long haul, inflation will eat away at your returns. This is why you may be better off with a diversified mix of stocks and bonds offered by an
.
Expense ratios
: Just like other mutual funds, money market funds charge a fee that helps pay the cost of running the fund. It’s called the expense ratio and can reduce your earnings from the fund. Therefore it’s important to check the expense ratio information on the fund’s prospectus before putting your money in it.
Alternatives to money market funds
There are several alternatives to money market funds, which may fit your needs better and offer similar yields. There are multiple factors that determine which type of account is the best fit for your current situation.
Below are several alternatives to consider for investing your cash in the short term:
Short duration bond funds and exchange-traded funds (ETFs)
Bond funds and ETFs can be a good alternative to money market funds with a higher potential yield. However, they can be higher risk and come with management fees and commissions.
Bond ETFs offer lower fees than bond funds and full transparency on what bonds they include in the fund. They can be purchased through a broker and traded on the open market like stocks.
Money market account
While money market accounts often get confused with money market funds, they are not the same thing. Money market accounts are FDIC-insured up to $250,000 and are offered by traditional financial institutions such as banks.
Unlike regular savings accounts, they often require a higher minimum balance but offer higher yields. Most times, these types of accounts offer check-writing privileges and other features similar to regular bank accounts.
High-yield savings account
High-yield savings accounts offer another alternative to money market funds. Just like money market accounts, they are FDIC insured and can be opened at traditional financial institutions.
Unlike money market accounts, they have a lower minimum balance requirement and offer check writing and debit card privileges in many cases.
Certificate of deposit (CD)
Certificates of deposit are a type of savings account with a fixed-term length of time such as three months, six months, one year, two years, and so on. In exchange for locking up your money for a fixed term, you will receive a fixed yield.
Like money market and high-yield savings accounts, CDs are also FDIC insured up to $250,000.
The longer the term, the higher the interest rate. Sometimes, CDs may pay higher interest rates than money market accounts but may require that you lock your money for a long period.
If you need to withdraw your money before the maturity date, you will be charged a penalty.
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