Money market funds are mutual funds that invest in high-quality short-term debts from governments, banks and corporations. They are different from the money market accounts you open at a bank. Money market funds are actually mutual funds that are baskets of securities. The baskets of investment securities have one goal and that goal should be the same as your own goal if you invest. There are good reasons to invest in a money market fund – if the time is right. Here are the facts about money market funds, how you invest and when you should and should not invest.
Consider working with a financial advisor as you weigh the relative benefits of money market funds vs. other highly liquid securities.
What Is a Money Market Fund?
Money market funds, also called money market mutual funds, are low-risk, conservative investments for investors interested in the safety of their principal. These funds invest in high-quality, highly liquid cash equivalents and short-term debt securities with a maturity of one year or less.
The risk associated with the securities in a money market fund is low. Because of the relationship of risk and return, that means the return is also low. Investors don’t usually invest in money market funds for their return. They invest because of the low risk and the relative safety of their principal.
Individual money market funds strive to keep their net asset value (NAV) at $1 per share. If the NAV rises above $1 per share due to interest generated by the assets in the portfolio, the excess is distributed to investors as dividends.
Money market funds should be distinguished from money market accounts (MMA). MMAs are offered by banks as an alternative to traditional savings accounts. These accounts pay slightly more interest than savings accounts and limit the number of withdrawals you can make per month. They are insured by the Federal Deposit Insurance Corporation (FDIC). Money market funds are not FDIC-insured and sometimes require a high initial investment – in some cases as much as $1,000,000. They are regulated by the Securities and Exchange Commission (SEC).
These are the types of securities in which money market funds invest:
- U.S. Treasury Bills: short-term government debt securities
- Commercial Paper: Corporate debt securities with a short-term maturity
- Banker’s Acceptances: Short-term debt guaranteed by a bank
- Certificates of Deposit: Savings certificate issued by a bank with low risk and a short maturity
- Repurchase Agreements: Government securities with a short-term maturity
Types of Money Market Funds
There are four types of money market funds. The securities in which each invests conforms to the type of fund it is:
- Treasury Funds: These funds invest in Treasury bills, bonds and notes that are frequently traded.
- Prime Funds (also called General Purpose Funds): They invest in non-Treasury securities like floating-rate debt and commercial paper of U.S. government agencies, corporations and government-sponsored entities.
- Government Funds: Government funds invest 99.5% of their assets in cash, Treasury securities and repurchase agreements. All investments have to be collateralized by cash and cash equivalents like U.S. government securities.
- Tax-exempt Funds: These funds invest in municipal bonds and other securities which are free from federal income taxes and often state taxes. These funds have a lower return than other money market funds due to their tax-exempt status.
When to Invest in a Money Market Fund
Money market funds are good investments if you use them like they are meant to be used. They are highly liquid. If you use them as a highly liquid cash substitute, then you have found the best use of the money market mutual fund. If, for example, you aren’t quite sure where you think the market is going to go, you may want to put some cash into a money market mutual fund so you will still have it if the market becomes very unpredictable. It serves as a hedge against the risk of the stock market.
However, even if the market is unpredictable, if inflation exists in the economy, you have to be careful about keeping your money in a money market mutual fund. If inflation is 6%, for example, and you are only earning 2% on your money market fund, then your purchasing power is being eroded.
On top of inflation eroding your purchasing power, most money market funds charge a fee for the administration of the fund. This expense ratio could be as high as 2% to 3%. If interest rates are low, so returns are low, and you have an expense fee to pay, it may not be the time to invest in a money market fund because that expense ratio will just further eat away at your return. On top of these factors, if you are holding cash in a money market fund outside a tax-advantaged retirement account, you take a tax hit as well.
How to Invest in a Money Market Fund
You can buy into a money market fund through your online broker or just on your own. You have to send in a check or make an online transfer for at least the minimum investment. Before you invest, take some time to compare several different money market funds and see which one conforms best to your own financial goals. Talk to your online broker about whether this is the time to buy into a money market fund or not.
The Bottom Line
Used in the right way, a money market fund can be a great place to park your cash with little risk. The returns normally exceed those of MMA. Compare different money market funds to see what best suits your needs. Keep in mind the four types of funds – Treasury, Prime, Government and Tax Exempt – and how much of your money market fund you want in government securities as opposed to private securities.
Tips on Investing
- Besides deciding whether you want your cash deposited in a money market fund or not, you also need to keep tabs on what percentage of your assets should be highly liquid, fixed-income as opposed to equity-based. That’s where a financial advisor can be helpful. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.
- Curious about how inflation is impacting you? Take a look at SmartAsset’s inflation calculator.
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