One common financial instrument that causes some investors a great deal of confusion is a money market fund. Many think these financial instruments are the same as the similar-sounding money market accounts, which closely resemble savings accounts.
However, money market funds, sometimes called money market mutual funds, are open-ended mutual funds that invest in short-term securities. Investment professionals typically design them to preserve cash. While money market funds carry a modest amount of risk, 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 serve the needs of certain cash-focused investors.
- What Is a Money Market Fund and How Does It Work?
- Types of Money Market Mutual Funds
- Who Might Consider Investing in a Money Market Fund
- Considerations When Investing in a Money Market Fund
- Money Market Funds vs. Money Market Accounts
- How To Buy Money Market Funds
- Are Money Market Funds Right For You?
As mentioned earlier, money market funds, or money market mutual funds, are open-ended mutual funds. Managers invest the funds in short-term, low-risk debt securities usually characterized by low volatility.
These funds typically trade at a $1 per share net asset value aka NAV. When the fund’s value begins to exceed the $1-per-share benchmark, funds will often distribute the amount over the benchmark (net of mutual fund fees) in the form of a dividend.
Although money market funds typically pay lower interest rates than certain other fixed-income investment vehicles, both are designed to provide 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.
This might explain a recent uptick in capital flowing into money market funds. In October 2019, Bank of America Merrill Lynch strategists, led by Michael Hartnett, noted that there had been a $322 billion inflow into money market funds over the previous six months. Hartnett stated that “bearish paralysis” over issues such as the trade war and Brexit led investors to the safety of these investment vehicles.
Such is the stability of these funds that many consider them as safe as cash, but that’s not exactly true. Unlike funds in a savings account, money invested in a money market fund is not protected by FDIC insurance.
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.
Varied financial instruments can make up a money market mutual fund. Fund managers have a wide variety of debt-related funds from which to derive secured income. The most common are as follows:
Retail funds limit ownership to individual investors and work to maintain the $1 NAV by factoring in both the costs to manage the fund as well as volatility. The fund will take some of its proceeds in the form of fees to cover costs. It might also impose “liquidity gates.” With a liquidity gate, owners cannot sell shares due to market conditions or other factors that temporarily take funds below required minimums.
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 invest at least 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. Government money markets don’t have liquidity fees, floating NAVs or redemption gates.
Prime funds, sometimes called “general purpose” funds, invest in corporate debt securities. These funds can invest in any U.S. dollar-denominated asset approved by the U.S. Securities and Exchange Commission, including commercial paper, certificates of deposit, corporate notes, private instruments and repurchase agreements.
Municipal money markets invest at least 80% of 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.
Given the variety of money market funds available, investors can likely meet their funding needs in a way that maximizes safety, returns and tax benefits.
|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|
Most individuals and institutions who turn to money market funds have one thing in mind: preservation of capital. The funds offer advantages over other fixed-income vehicles such as savings accounts and bonds. For one thing, money markets provide liquidity. Assuming no liquidity gates are in place, this means that 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 higher degree of safety than bonds. For example, a money market based on bonds might hold these notes from multiple borrowers, protecting money market investors in case of a default. They also tend to come at a low cost. In addition, these funds typically derive their revenue from expense ratios as opposed to transaction fees when holders buy or sell.
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 are the annual fees people and institutions pay to own a fund, and they can vary widely. Investors might find funds that charge expense ratios below 0.25%, though some might require restrictions such as monthly minimum balances. Investors wanting fewer restrictions might have to pay a higher expense ratio. A survey of 15 popular money market funds showed expense ratios ranging from 0.09% to 0.45%.
Most money market funds focus on maintaining stable values. Hence, they set an objective of a $1-per-share NAV. Though some institutional funds allow the NAV to float based on market or other conditions, in most cases funds will employ payouts or liquidity gates to maintain the $1-per-share level.
Even the safest funds must deal with exposure and risk. The most well-known case of exposure involved the previously-mentioned fall of the NAV to 97 cents per share following the 2008 Lehman bankruptcy. Other risks include government regulation and interest rates. Money market funds based on foreign assets also face exposure in terms of a country’s regulatory, political or economic turmoil.
The main risks surrounding money market funds have to do with liquidity and price. Liquidity risk involves the ability to sell shares at any time. When the fund must maintain a $1 per share NAV, it might temporarily forbid selling until the NAV rises back to that price. In the case of price risk, some institutional funds allow the NAV to float. This means investors could receive more or less than $1 per share when they cash out.
One concern in recent years is negative interest rates. Funds need positive rates to generate the cash needed to cover their fees and payout returns to money market fund investors.
Laurence Booth, CIT Chair of Structured Finance at the University of Toronto’s Rotman School of Management, fears this could destroy the industry. He said that if interest rates go negative, fund managers might have to pay depositors to keep money in money market funds. Booth calls this a “disaster for these funds.”
A big point of confusion regarding money markets involves the difference between money market funds and money market accounts.
As mentioned before, a money market fund is a type of mutual fund. However, a money market account functions as a bank account. Similar to savings accounts, money market accounts only allow a minimum number of withdrawals per month, and the money has FDIC protection. In this way, they function more like savings accounts than money market funds.
But there are differences between money market accounts and savings accounts. For one, money market accounts typically require a minimum balance, often in the $2,500 and $10,000 range. They also tend to pay higher interest rates than savings accounts.
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Purchasing a money market fund is similar to buying a stock: You can log on to your brokerage account and buy the fund of your choice. Given the amount of information online, you might prefer to research these securities on your own. Thanks to the proliferation of brokerages that offer zero-fee transactions, you can save money in the process.
If you do want help choosing the right money market fund, some online brokerages offer advice for a fee. Otherwise, you can find a financial advisor. With the help of such experts, especially a fiduciary financial advisor, you can determine the money market funds that best suit your needs.
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 safe place to store funds and earn a modest return. In most cases, they also provide liquidity when necessary.
People who need to preserve less than $250,000 (the FDIC insurance limit) might want to consider a money market account instead. But those who can handle a minimum balance and need to protect more than $250,000 should go with the money market fund.
Again, one risk is that the NAV might fall below $1 per share in rare circumstances. Even so, the diversification you find in a money market fund offers more protection than a bond or an uninsured bank deposit. Moreover, if a compelling investment opportunity suddenly appears, you’ll usually have instant access to the funds.
For savers who want to store a large amount of cash that they can access quickly, money market funds can be an excellent investment option.
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