Money Market Fund: Definition, Types, Advantages & Risks (2024)

Money market funds are useful vehicles that have a role to play in almost any investment portfolio. However, you need to understand the nature of these funds to decide if andhow they fit into your investing objectives.

What Is a Money Market Fund?

A money market fund is a mutual fund that invests solely in cash andcash equivalent securities, which are also calledmoney marketinstruments. These vehiclesare very liquid short-terminvestments with high credit quality.

Money market funds generally invest in such instruments as:

  • Certificates of deposit (CDs)
  • Commercial paper
  • U.S. Treasuries
  • Bankers' Acceptances
  • Repurchase agreements

Securities and Exchange Commission (SEC) rules dictate the fund portfolio must maintain a weighted average maturity (WAM) of 60 days or less.Just like other mutual funds, money market funds issue redeemable units (shares) to investors and must follow guidelines set out by the SEC. All the attributes of a mutual fund apply to a money market mutual fund, with one exception that relates to its net asset value (NAV). We'll take an in-depth look at this exception later on.

Money Market Funds vs. Money Market Accounts

While they sound highly similar, money market funds differ from money market accounts (MMAs). The key difference is that the former is sponsored by fund companies and carries no guarantee of principal,while the latter are interest-earning savings accounts offered byfinancial institutions, with limited transaction privilegesand insuredby theFederal Deposit Insurance Corporation (FDIC). A money market account usually pays a higher interest rate than a bank savings account, but a slightly lower interest rate than a CD or the total return of a money market fund.

In addition, money market accounts restrict the accessibility of account balances through check writing, while money market fund withdrawals are generally available on demand. Some banks may allow up to six withdrawals per statement cycle for MMAs while others offer no check-writing option at all. Many money market funds offer unlimited check writingbut require checks to be written for a minimum dollar amount.

Unique Qualities of Money Market Funds

Money market funds are special for three reasons:

1. Safety

The securities in which these funds invest are stable and generally safe investments. Money market securities provide a fixed return with short maturities. By purchasing debt securities issued by banks, large corporations, and the government, money market funds carry a low default risk while still offering a reasonable return.

2. Low Initial Investment

Money market securities generally have large minimum purchase requirements thatmakeit difficult for the vast majority of individual investors to buy. In contrast, money market fundshave substantially lower requirements thatare even lower than average mutual fund minimum requirements. As a result, money market funds allow investorsto take advantage of the safety related to a money market investment at lower thresholds.

3. Accessibility

Money market fund shares can be bought and sold at any time and are not subject to market timing restrictions. Most of these funds provide check-writing privileges and offer investors same-day settlement, which is similar to trading money market securities.

Taxable vs. Tax-Free Money Market Funds

Money market funds are divided into two categories: taxable and tax-free. If you’re buying a taxable fund, any returns from the fund are generally subject toregular state and federal taxes.

Taxable funds mainly invest in U.S. Treasury securities, government agency securities, repurchase agreements, CDs, commercial paper, and bankers’ acceptances. Many other types of investments are eligible for taxable money market funds. For instance, if you likethe housing sector, you can buy a money market fund that solely invests in Fannie Maes.

Tax-free fundsdo not provide as many options. These funds invest in short-term debt obligations issued by federally tax-exempt entities (municipal securities) and have a lower yield. In some cases, you can purchase tax-free funds that are exemptfrom both state and local taxes; however, these kinds of exemptions are exceptions rather than the norm.

Calculating Tax-Free Money Market Fund Yields

If you are deciding between tax and tax-free funds, it is important to calculate whether the tax savings created by the tax-free fund will be enough to make its lower yield worthwhile. Taxable funds generally have higher returns—nominally. Butif the tax on those returns effectively wipes out the additional return, the more optimal choice is the tax-free fund.

You can't just compare the two funds' yields by themselves. Instead, you need toconvert the tax-free yield into an equivalent taxable yield. This can be accomplished with the following equation:

Taxableequivalentyield = tax-free yield/ (1−marginaltaxrate)

​For example, let's say you are in the 24% tax bracket and need to choose between a taxable money market fund with a yield of 1.5% and a tax-free fund with a yield of 1.3%. By converting the tax-free yield into a taxable equivalent yield (using the formula above), we get 1.71%:

0.013 ÷ (1−0.24) = 0.0171

So, the choice is obvious: The tax-free money market is the way to go because the tax savings provide a better yield. The higher the tax bracket, the better the taxable equivalent yield becomes.

Money Market Fund Risks

No asset comes without caveats. Before you invest in a money market fund, be aware of three areas of concern:

Expense Ratio

As with regular mutual funds, money market funds have expenses. A fund with a higher-than-average expense ratio is going to eat into relatively lowreturns.

Investment Objective

If you are a long-term investor building a retirement fund, alarge position in money market funds is not appropriate. On average,these funds generate incomejustslightly above the rate of inflation, which isnotsufficient to build an adequate nest egg. Instead, money market funds should be used as a portfolio management tool to park money temporarily or accumulate funds for an anticipated cash outlay.

Risk Factors

Although they are relatively low-risk, money market funds are not entirely risk-free. In 1994, the Community Bankers U.S. Government Money Market Fund ofDenver got in trouble when the prices of the derivatives that dominated its portfolio dropped heavily. The Securities and Exchange Commission liquidated the fund, and investors (all institutional) received only $0.96 on the dollar.

In another case, theReserve Primary Fund failed in September 2008. The prestigious fund held hundreds of millions in short-term loans to Lehman Brothers and, when that investment firm went bankrupt, a wave of panicked selling ensued among Reserve's own investors. The fund's share price dropped to $.97; unable to meet redemptions, Reserve ultimately was forced to fold. To avoid an industry meltdown, the U.S. Treasury had to step in and guarantee other money market funds.

This so-called "breaking the buck"—when a money market fund's net asset value (NAV) falls below the traditional $1 level it's supposed to maintain, leading to the fund's liquidation—is admittedly a remote possibility. (Community Bankers and Reserve Primary are the only two recorded failures in the history of money market funds, going back to 1983.) But it's a reminder that every investment carries some risk, even conservative ones.

The Bottom Line

Whether you decide to use money market funds as an investment vehicle or as a temporary place to stash money while waiting for the right security to buy, make sure you know as much as possible about a particular fund, its characteristics, its investment strategy, and how its expenses compare to comparable vehicles. Money market funds are often touted as the same as cash. They're not. No investment is—nor would you want it to be.

As an enthusiast with a deep understanding of financial markets and investment vehicles, I can confidently discuss the concepts presented in the article about money market funds. My knowledge is rooted in both theoretical understanding and practical experience in the field of finance.

Money Market Funds Overview: Money market funds are crucial components in many investment portfolios. These mutual funds focus exclusively on cash and cash equivalent securities, also known as money market instruments. These instruments include certificates of deposit (CDs), commercial paper, U.S. Treasuries, bankers' acceptances, and repurchase agreements. To adhere to Securities and Exchange Commission (SEC) rules, these funds maintain a weighted average maturity (WAM) of 60 days or less.

Key Characteristics of Money Market Funds:

  1. Safety: Money market funds invest in stable and safe securities, providing a fixed return with short maturities. By purchasing debt securities from reputable entities like banks, large corporations, and the government, these funds carry a low default risk while offering reasonable returns.

  2. Low Initial Investment: Money market funds have lower minimum purchase requirements compared to other investment options, allowing individual investors to access the safety associated with money market investments at lower thresholds.

  3. Accessibility: Money market fund shares are easily bought and sold, not subject to market timing restrictions. Most funds provide check-writing privileges, allowing investors same-day settlement, similar to trading money market securities.

Taxable vs. Tax-Free Money Market Funds: Money market funds are categorized into taxable and tax-free. Taxable funds are subject to regular state and federal taxes, investing in various securities like U.S. Treasury securities, repurchase agreements, and commercial paper. Tax-free funds invest in short-term debt obligations issued by federally tax-exempt entities (municipal securities), offering a lower yield.

Calculating Tax-Free Money Market Fund Yields: When deciding between taxable and tax-free funds, investors must calculate whether the tax savings of the latter justify its lower yield. The taxable equivalent yield is determined using the formula: [ \text{Taxable Equivalent Yield} = \frac{\text{Tax-Free Yield}}{(1-\text{Marginal Tax Rate})} ]

Money Market Fund Risks: While money market funds are relatively low-risk, investors should be aware of potential concerns:

  1. Expense Ratio: Money market funds have expenses, and a higher-than-average expense ratio can impact returns, especially given their relatively low returns.

  2. Investment Objective: These funds are not suitable for long-term investors building a retirement fund. They are better utilized as a temporary parking place for funds or for accumulating money for anticipated cash outlays.

  3. Risk Factors: Despite being low-risk, money market funds are not entirely risk-free. Historical cases, such as the failures of the Community Bankers U.S. Government Money Market Fund in 1994 and the Reserve Primary Fund in 2008, underscore the importance of recognizing potential risks.

In conclusion, whether using money market funds as an investment vehicle or a temporary holding place for funds, it is essential for investors to thoroughly understand a fund's characteristics, investment strategy, and expenses. Money market funds are not synonymous with cash, and every investment carries some level of risk, even in conservative options.

Money Market Fund: Definition, Types, Advantages & Risks (2024)
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