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MONEY MARKET FUNDS: EVERYTHING YOU NEED TO KNOW
Learn how to choose the best money market funds that suit your investment needs.
Email
Kent Thune
Reviewed by: Lisa Barr
,
Edited by: Lisa Barr
View Bio Follow Author
Money market funds in the aggregate are offering some of the highest yields seen
in decades. Since there are many different types of funds in the money market
space, investors need to understand the choices while considering their needs,
including yield and taxation.
Learn the basics on money market funds and how to choose the best funds for your
investing needs.
WHAT IS A MONEY MARKET FUND?
A money market fund is a type of mutual fund that invests in low-risk,
short-term debt securities. It is designed to provide investors with a
relatively safe and liquid investment option that offers competitive returns
compared to traditional savings accounts. The primary objective of a money
market fund is to preserve the principal investment while generating income
through interest payments.
Investors in money market funds often include individuals, corporations and
institutional investors who seek a safe and short-term place to park their cash
holdings. These funds are typically used for short-term cash management
purposes, such as temporarily holding funds before deploying them into other
investments or meeting near-term financial obligations.
HOW DO MONEY MARKET FUNDS WORK?
Money market funds aim to maintain a stable net asset value (NAV) per share,
usually set at $1, which means the value of each share remains constant. To
maintain this stability, money market funds invest in instruments such as
Treasury bills, certificates of deposit, commercial paper and short-term
corporate debt.
The securities held in a money market fund typically have a short maturity
period, usually less than 13 months, and are considered to have a high credit
quality.
WHAT IS THE FIRST MONEY MARKET FUND?
The first money market fund, often considered the prototype for this type of
investment, was launched under the name “The Reserve Fund” and was created by
Bruce R. Bent and Henry B. R. Brown in 1971. The fund was initially designed to
provide investors with a higher-yielding alternative to bank savings accounts
by investing in short-term debt instruments.
The concept of the money market fund was so successful that it quickly gained
popularity and paved the way for the development of similar funds by other
financial institutions. The Securities and Exchange Commission (SEC) recognized
the need for regulations specific to money market funds and subsequently
established guidelines to ensure their stability and investor protection.
WHAT ARE THE TYPES OF MONEY MARKET FUNDS?
There are several types of money market funds, each with its specific
characteristics and investment focus. Here are some common types:
* Government money market funds: These funds primarily invest in short-term
debt securities issued by the government and government agencies. They
typically focus on Treasury bills, Treasury notes and other government-backed
securities.
* Treasury money market funds: Like government funds, Treasury money market
funds focus on government securities; however, they invest exclusively in
U.S. Treasury securities.
* Prime money market funds: Prime funds invest in a broader range of short-term
debt securities, including commercial paper, certificates of deposit and
other corporate debt instruments. These funds seek to maintain a slightly
higher yield by taking on a slightly higher level of credit risk compared to
government funds. Prime funds may invest in both domestic and international
debt securities.
* Tax-exempt money market funds: These funds invest in short-term debt
securities issued by state and local governments, municipalities and other
tax-exempt entities. The income generated by these funds is generally exempt
from federal income tax and may be exempt from state and local taxes, making
them attractive for investors in higher tax brackets seeking tax-efficient
investments.
ARE MONEY MARKET FUNDS SAFE INVESTMENTS?
Money market funds are generally considered safe investments, but they are not
entirely risk-free. Certain types of funds may be safer than others, in terms of
credit risk. For example, government and Treasury money market funds are
considered safer than other types. These funds are backed by the full faith and
credit of the U.S. government, making them highly secure.
WHAT ARE THE PROS AND CONS OF INVESTING IN MONEY MARKET FUNDS?
Money market funds offer several advantages, including stability, liquidity and
competitive yields. However, there are some potential disadvantages, such as
credit risk, interest rate risk and inflation risk, that investors should
consider when evaluating them as an investment option.
Here are some pros and cons of money market funds:
PROS OF MONEY MARKET FUNDS
* Liquidity: Money market funds provide high levels of liquidity, allowing
investors to easily access their funds. Typically, investors can make
withdrawals or redeem shares on any business day, providing quick access to
cash when needed.
* Stability: Money market funds aim to maintain a stable NAV per share, usually
set at $1. This stability makes them attractive for conservative investors
seeking to preserve their principal investment.
* Low risk: Money market funds invest in low-risk, short-term debt securities
issued by governments, corporations or other entities with high credit
quality. While they are not risk-free, they are generally considered to have
lower risk compared to other investment options.
* Diversification: Money market funds typically hold a diversified portfolio of
securities, spreading the risk across multiple issuers. This diversification
can help mitigate the impact of a default by any single issuer.
* Competitive yields: Money market funds aim to provide competitive yields
compared to traditional savings accounts and other low-risk investments.
While the yields may not be as high as riskier investments, they offer a
reasonable return for the level of risk involved.
CONS OF MONEY MARKET FUNDS
* Potential for low returns: Money market funds tend to provide relatively
lower returns compared to other investment options such as stocks or bonds.
* Inflation risk: Money market funds typically produce yields that are
significantly below inflation. For example, when inflation was averaging
2%-3%, most money market funds were yielding 1% or less. When inflation hit a
40-year peak of 9.1% in 2022, the highest-yielding money markets were
yielding around 5%.
* Interest rate risk: Money market funds are sensitive to changes in interest
rates. If interest rates decline, the yield on new investments may decrease,
affecting the fund's overall return. However, money market funds generally
have shorter durations, making them less sensitive to interest rate
fluctuations compared to longer-term bonds.
* Credit risk: While money market funds aim to invest in low-risk securities,
there is still a minimal risk of default by the underlying issuers. A
significant default or credit event in the fund's portfolio could potentially
impact its stability and the value of its shares.
* Fees: Money market funds charge management fees and other expenses, which can
reduce the overall return. It's important to compare expense ratios among
different funds and consider the impact of fees on the fund's performance.
* Regulatory changes: Money market funds are subject to regulatory oversight,
and changes in regulations or market conditions can impact their operations
and investor experience. For example, regulatory reforms implemented after
the global financial crisis introduced additional requirements and potential
restrictions on certain money market funds.
HOW TO CHOOSE THE BEST MONEY MARKET FUNDS
When choosing the best money market funds, there are several factors to
consider, including yield, expenses, credit quality and fund size. In the fund
selection process, investors should consider their investment goals, risk
tolerance and tax considerations.
Here are some key aspects to consider for choosing the best money market funds:
* Yield: Evaluate the fund's historical yield, which indicates the income
generated by the fund's investments. Although money market funds aim to
provide competitive yields, it's essential to assess the yield relative to
other funds and prevailing market conditions.
* Expense ratio: Consider the expense ratio, which represents the fund's annual
operating expenses as a percentage of its average net assets. Lower expense
ratios can contribute to higher returns for investors, so compare the expense
ratios of different funds.
* Credit quality: Assess the credit quality of the fund's underlying
investments. Look for funds that primarily invest in high quality, low-risk
debt securities issued by reliable entities. Credit ratings provided by
agencies such as Standard & Poor's, Moody's or Fitch can give you an idea of
the creditworthiness of the securities held by the fund.
* Fund size and liquidity: Larger funds generally have more stability and
liquidity compared to smaller funds. Investors can evaluate fund size by
comparing its assets under management to other funds with similar
objectives.
* Fund provider's reputation: Consider the reputation and track record of the
fund provider. Look for established financial institutions with a history of
managing money market funds and a strong reputation for stability and
reliability.
BOTTOM LINE
Money market funds are generally a safe way to earn higher yields than the
typical bank savings account. However, these funds are not entirely risk-free.
It's crucial to carefully review the prospectus and understand the specific
risks associated with the various types of funds before investing in any of
them.
Kent Thune
| Contact: kent.thune@etf.com
Kent Thune is a finance writer for etf.com, focusing on educational content.
Before coming to etf.com, he wrote for numerous investment websites, including
Seeking Alpha and Kiplinger. Thune is also a practicing Certified Financial
Planner and investment advisor based in Hilton Head Island, SC, where he lives
with his wife and two sons.
View Bio Follow Author
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