A money market fund can cause new investors some confusion. Some think they are the same as the similar-sounding money market accounts, which closely resemble savings accounts. However, they’re very different.
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What Is a Money Market Fund?
Money market funds, or money market mutual funds, are open-ended mutual funds that invest in short-term securities. This means they are pools of money from multiple investors that can sell an unlimited amount of shares. Investment professionals typically design them to have less risk so that they preserve cash. But they can produce higher returns while offering more safety and liquidity than other fixed-income investment vehicles.
These funds will not make you wealthy, but they can be a great place to park your savings.
Money market funds are built with short-term, low-risk debt securities that usually have low volatility. These funds seek to trade at a flat $1 per share net asset value. They can also provide income to investors through dividends.
How Money Market Funds Work
Although money market funds typically pay lower interest rates than certain other fixed-income investment vehicles, the tradeoff is their safety and stability. Investors who need to save cash for emergencies — or simply want to store money while waiting for their next equity investments — often choose money market funds.
However, it’s important to note that unlike some other options, like savings accounts, money invested in a money market fund is not protected by FDIC insurance.
Breaking the Buck
When funds fall below the $1-per-share benchmark, it’s called “breaking the buck.” This doesn’t happen often, but it did occur in September 2008 after Lehman Brothers declared bankruptcy. The crisis caused some money market funds to fall to 97 cents per share. When that occurred, the government stepped in and insured all stable-value funds.
Despite this rescue, money market mutual funds do not typically benefit from insurance guarantees or government intervention.
So, what is the point of a money market fund? They are a relatively safe way to invest and are generally more stable and accessible than other investment options.
Types of Money Market Mutual Funds
What is an example of a money market fund? Varied financial instruments can make up a money market mutual fund. The most common are as follows:
Retail Money Market Funds
Retail funds limit ownership to individual investors.
Institutional Money Market Funds
As the name implies, institutional money market funds serve institutions rather than individuals. Unlike most money markets, the NAV here can float based on market conditions. Companies and pension funds often purchase this type of mutual fund.
Government Money Market Funds
Government money market funds invest a minimum of 99.5% of their funds in government securities. This usually means U.S. Treasuries, but could also mean government-sponsored enterprises such as Fannie Mae and Freddie Mac.
Both retail and institutional investors can buy this type of money market fund.
Prime Money Market Funds
Prime funds, sometimes called “general purpose” funds, invest in short-term bank and corporate debt.
Municipal Money Market Funds
Municipal money markets invest their assets in tax-exempt bonds issued by municipalities. These funds receive exemptions from federal income tax and, in some cases, exemptions from state personal income tax.
Here’s a look at the different types of money market mutual funds:
| Fund Type | Primary Types of Instruments Held |
|---|---|
| Retail Funds | Designed for individual investors; works to maintain the $1-per-share NAV |
| Institutional Funds | Serves institutions such as companies and pension funds; can have a floating NAV |
| Treasury | At least 99.5% invested in cash and U.S. Treasuries, with at least 80% invested in Treasuries |
| Treasury Only | At least 99.5% invested in cash, U.S. Treasuries and/or repurchase agreements, with at least 80% invested in Treasuries and repurchase agreements |
| Government | At least 99.5% invested in cash, U.S. Treasuries and/or repurchase agreements, with at least 80% invested in Treasuries and repurchase agreements; this can also include government-sponsored enterprises such as Fannie Mae and Freddie Mac, but the U.S. Treasury neither issues nor guarantees those securities |
| Prime (General Purpose) Funds | Assets invested in any approved, U.S.-dollar denominated money market instruments as defined by the SEC; this includes commercial paper, certificates of deposit, corporate notes, private instruments from either foreign or domestic issuers, and reverse repurchase agreements |
| National Municipal | Invests at least 80% of fund’s assets in municipal securities where interest is exempt from federal income tax |
| State Municipal | Invests at least 80% of fund’s assets in municipal securities where interest is exempt from federal income tax and personal state income taxes |
Benefits of Money Market Funds
The main benefits of money market funds are:
- Low volatility
- Liquidity, or accessible cash
- Higher interest than traditional savings accounts
They are known as “cash alternatives” because they are highly liquid and generally safe.
Risks Associated With Money Market Funds
There are three primary risks involved with investing in money market funds:
- Interest rate risk: When interest rates rise, bond and fixed-income prices fall. This is usually not a large risk with money market funds. This is because they are stocked with very short-term securities, but it is a risk.
- Credit risk: Most money market fund investments are top-quality. But there’s always a risk that an issuer gets downgraded or defaults. This could impair the return of the fund.
- Liquidity risk: One of the key attributes of a money market fund is how accessible, or liquid, the cash is. During a financial crisis, it can be difficult to access the funds in any of your accounts.
Comparing Money Market Funds With Other Options
Money market funds are just one type of liquid, high-yielding investment that investors can use to park their cash. Here are some of the others.
Money Market Funds vs. High-Yield Savings
The key distinction between these two types of investments is that high-yield savings accounts carry $250,000 in FDIC insurance. Money market funds do not have this insurance. However, money market funds are still low-risk. They may also offer even higher yields than certain high-yield savings accounts.
Money Market Funds vs. Money Market Accounts
A money market fund is a mutual fund. Meaning it is a pool of money from multiple investors. A money market account functions as a bank account.
Similar to savings accounts, money market accounts used to limit withdrawals to six per month. This was suspended during the COVID-19 pandemic and for the most part remains a restriction of the past. Unlike money market funds, money market accounts carry FDIC protection. All in all, money market accounts function more like savings accounts, whereas money market funds are investment funds.
Money Market Funds vs. Certificates of Deposit (CDs)
Money market funds are more liquid than CDs. CDs generally impose stiff early withdrawal penalties if you take money out before they mature. However, CDs generally pay fixed interest rates, whereas the interest paid on money market funds can fluctuate daily.
How To Choose the Right Money Market Fund
While structurally most money market funds are similar, there are important distinctions to take into account when picking the right one for you. Here are some of the most important:
- Type of fund: Government funds may be safer than corporate funds, for example, although they may pay a lower yield. Which is best for you depends on your personal needs.
- Expense ratio: Expenses drag down the return you’ll earn on a money market fund, so lower is better.
- Yield: One of the main reasons to own a money market fund is to earn interest, so all other things being equal, a higher yield is more desirable.
- Fund minimums, requirements or restrictions: Some money market funds may have high minimum balance requirements or withdrawal restrictions making them a poor choice for certain investors.
- Accessibility: Unlike money market accounts, or many savings accounts, money market funds don’t offer ATM and check writing access. Finding the most liquid fund may be an important concern for some account holders.
How To Invest in Money Market Funds
Purchasing a money market fund is similar to buying a stock. You can simply log on to your brokerage account and buy the fund of your choice.
If you do want help choosing the right money market fund, some online brokerages offer advice for a fee. Otherwise, you can find a fiduciary financial advisor.
Tax Considerations for Money Market Funds
Money market funds pass the income they generate through to their shareholders. Its taxation depends on its nature. Regular interest and dividend payments, for example, are fully taxable as ordinary income. If there are any capital gains distributions, they are taxed as capital gains. Some money market funds invest in tax-exempt securities, in which case the interest and dividends they generate may be tax-free.
Who Might Consider Investing in a Money Market Fund?
Most individuals and institutions who turn to money market funds have one thing in mind: preservation of capital. But in most cases, account holders can have immediate access to their funds.
Moreover, money markets usually offer higher interest rates than standard savings accounts. And while money market funds don’t benefit from FDIC insurance, they have a high degree of safety, as they invest in high-quality, ultra short-term securities.
Considerations When Investing in a Money Market Fund
Even though money market funds offer certain benefits you can’t get with other financial instruments, these funds don’t necessarily suit all fixed-income investors. For this reason, individuals and institutions should consider the following:
Expense Ratios
Expense ratios are the annual costs of owning a fund, and they are deducted from the income the fund generates. Especially in a money market fund, in which capital appreciation is not an option, a low expense ratio is critical.
Exposure
Even the safest funds must deal with exposure and risk. Although money market funds are generally able to maintain a stable NAV of $1, some funds may own assets that are riskier than others.
Interest Rates
After years of paying above-average yields, money market account yields seem likely to fall, as the Fed has announced it intends to begin cutting interest rates in the near future.
Are Money Market Funds Right For You?
Is a money market fund a good investment? Money market funds work best for those who need instant access to a large amount of cash. These funds will not make you rich, but they will give you a relatively safe place to store funds and earn a modest return, often above that offered by a savings account.
John Csiszar contributed to the reporting for this article.
This article originally appeared on GOBankingRates.com: What Is a Money Market Fund?
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
