- Money market mutual funds are a fixed-income mutual fund that invests in short-term, high-quality debt. As such, money market funds offer less risk and more liquidity.
- If you are sitting on cash, you may want to consider purchasing shares of a money market fund instead. Money market funds are nearly as liquid as bank accounts but generally provide higher rates of return.
- As with any investment, do your homework before purchasing shares of a money market fund. There are pros and cons associated with this investment type, as well as with various investment providers, you’ll need to consider.
As you jump into the world of investing, you’ll quickly learn that there are many different types of investments. Diversification is critical since it can help lower risk and offset potential losses. One type of investment that you can consider adding to your portfolio is a money market mutual fund. In this article, we’ll outline what you need to know about money market funds so you can determine the role they’ll play among your investments.
What Is a Money Market Mutual Fund?
Money market mutual funds, or money market funds for short, are a type of fixed-income mutual fund. Money market funds invest in short-term, high-quality debt. Money market mutual funds provide investors with low-risk assets, as they are less volatile than stocks and bonds.
Money market fund managers strive to maintain a net asset value (NAV) of $1 per share, meaning these funds are quite stable and reliable relative to other investments since they’re designed to preserve their value by taking on little risk. NAV typically applies to open-ended funds, which are those that allow you to purchase or sell shares at any time. Money market accounts are a type of mutual fund that’s open-ended.
Investors who buy shares of a money market fund purchase a compilation of instruments like certificates of deposit from banks and short-term debt securities such as U.S. Treasury bills (T-bills), commercial paper, or repurchase agreements. Essentially, money market funds allow you to purchase short-term debt from government agencies, banks, and corporations. Funds will blend these different types of securities and instruments to minimize fluctuations in value while paying interest to the investor.
A money market fund likely offers lower returns than other asset classes like stocks. But they allow you to increase earnings from the value of your investment more than if you left the cash in a bank account. These funds are also attractive because you can liquidate them almost as quickly as cash in the bank. Many money market funds allow you to liquidate your shares as soon as the next day.
Types of Money Market Instruments
There are different types of securities and instruments that can make up a money market mutual fund. For all these types, fund managers focus on the highest quality instruments to maintain the stability of the value of the fund.
Certificates of Deposit (CDs)
A CD is a short-term savings certificate issued by a financial institution. CDs typically are fixed-term. Typically, the longer the fixed-term, the higher the rate of return.
Treasury Bills (T-Bills)
The U.S. Treasury issues T-bills. T-bills are short-term debt obligations backed by the U.S. government. Typically, T-bills have an average maturity of less than a year. Essentially, when you purchase a U.S. Treasury security, you are lending money to the government. When the bill matures, the government will return your principal plus interest.
Commercial Papers (CPs)
CPs are similar to T-bills, except that corporations issue them. These short-term debt instruments are unsecured, meaning a guarantor does not protect it. Corporations issue CPs to finance things like their accounts payable and inventories. Most corporations don’t issue CPs that take more than 270 days to mature.
Repurchase Agreements (Repos)
A repo is an investment tool that involves the sale of securities. Government securities are most often used in repurchase agreements. The selling party agrees to repurchase the security at a fixed time and price.
When and How to Use Money Market Funds
Money market mutual funds could be a useful tool to minimize risk and increase earnings. At the time of writing this article, money market funds typically yield between 1.5% and 2.5% (lower for tax-free funds, such as municipal bond funds), which is greater than a high-yield savings account. Since the funds tend not to lose value, they are an excellent tool to provide stability to your portfolio of stocks and bonds and are also an excellent choice for those who have a low tolerance for risk.
Those with a short-term investing horizon might be most interested in money market funds. For instance, if you’re saving for a house or planning a wedding and need your money within the next year, a money market fund is an excellent way to help pad your savings, mainly because your investment is stable in value, you can pull funds at any time and you’ll earn a higher rate than with a savings account.
Money market funds also serve as an excellent emergency fund. An emergency fund, otherwise known as a rainy day fund, is there for unexpected events, like your car breaking down or you losing your job. By using a money market account, you can maintain liquidity but boost earnings more than you would leaving your funds in a bank account. You could also park money in a money market mutual fund if you’re waiting for an investment opportunity.
In summary, money market funds are practically just as liquid as cash and bank accounts. If you’re in a situation where you would consider leaving cash in a bank account because of how accessible it is, consider instead moving to a money market fund. You’ll have access just as quickly, but you’ll earn a higher rate of return. There are, however, risks with the money market fund to be considered.
Things to Consider When Investing
Before you jump in and put your money into a money market fund, there are some things you’ll want to consider.
Risks and Returns
As with any investment, the first thing to consider is your portfolio and the risks and returns associated with it. Evaluate your current investing goals and profiles. Consider factors like your risk tolerance and whether you have a desired balance of fixed-income investments that can provide income and stability, and stocks that can be riskier but can provide earnings and growth.
Money market funds offer less risk than most investments thanks to federal regulation. These funds must have short maturities and be high in credit quality. Additionally, these funds have minimal interest rate risk exposure, meaning there isn’t much chance of interest rates rising and the value of funds declining because they are designed for the short-term.
However, it is possible to suffer losses when investing in a money market mutual fund. Unlike savings or checking deposits at banks, money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC). Because they are not FDIC-insured, you aren’t protected if one of the institutions that you invested in were to, say, go bankrupt or default on their debt.
Furthermore, although the rates of return for a money market mutual fund tend to be higher than bank accounts, they’re not as high as some other fixed-income funds, which can invest in a wider variety of bonds that have longer time frames and lower credit grades to target higher returns.
The tradeoff to this is that money market funds are much more predictable and subject to fewer fluctuations. They can provide you with a way to bring stability to your portfolio while still earning interest.
Choosing a Fund
The last thing to consider is which fund you want. Different brokerages, including Vanguard and Fidelity, among many others, offer money market mutual funds. Make sure you compare funds and find the one that’s right for you. Especially consider the minimum investment required as this factor can determine any fees charged on your account.
One of the most critical things to compare is the expense ratio. This figure indicates how much the fund will charge in administrative, advertising, and management fees each year — the lower the rate, the better. Also, look into the purchase and redemption costs. These are the prices that brokerages will charge on top of the share price to buy or sell fund shares. Many mutual funds do not have purchase or redemption costs.
The last consideration when deciding on a mutual fund is the associated taxes. Money market fund gains are not tax-exempt unless they come from municipal securities. Municipal securities are those issued by state and local municipalities, and income from their debt is tax-exempt and so these funds usually offer lower yields than their taxable equivalents.
If you are concerned about how your investment accounts will impact your federal income tax, you may prefer instead to deposit the taxable money market funds into tax-advantaged accounts, such as your IRA or 401(k).
Are Money Market Mutual Funds Right for You?
Money market funds can be an integral part of your savings and investments, allowing you to diversify your portfolio with a low-risk investment tool. Although the returns aren’t spectacular, they are more than you’d earn by leaving money in a bank account (although remember these are not FDIC-insured). Money market funds are highly liquid and stable in value as well, allowing you to save for a short-term goal.
Be sure to compare various funds and brokerages when choosing a money market mutual fund. Look for those funds with low expense ratios, low minimum deposits, and little (or no) purchase and redemption fees. Watch out for account minimums that may come with fees. Doing so will allow you to keep more of the interest you earn on cash that you have sitting around.
If you’re a new investor and are curious about how money market funds and other investments can fit into your investment strategy, our guide for investing for beginners will provide you with the information you need to get started.