Investors often focus on high returns, but from time to time, they just need a place where they can park cash and quickly retrieve it. Enter money market mutual funds, a pooled investment vehicle that provides modest returns but high liquidity and safety.
What is a money market fund?
A money market mutual fund is a type of mutual fund that invests in short-term, high-quality debt instruments. Investors can purchase shares from a fund provider, from a bank, or using a traditional or online brokerage account. The fund may set a minimum investment, sometimes ranging from $500 to $5,000 or more, but some providers waive the minimum if you set up automatic monthly deposits or invest using certain retirement accounts. In turn, the money market fund invests the money in low-risk vehicles such as certificates of deposit, government-backed securities, and commercial paper. The fund then pays dividends on a regular basis. Because they invest in low-risk securities, money market funds typically provide modest returns.
The Securities and Exchange Commission (SEC) requires money market funds to invest in debt securities with maturities of 13 months or less (or 25 months if it's a government security). The fund portfolio must also maintain a weighted average maturity (WAM) of 60 days or less. Although some securities in the portfolio might mature in a year or longer, others might mature the next day, keeping the average under 60.
These requirements help ensure the portfolio isn't tied up in long-term investments, so the fund remains highly liquid. Investors can deposit or withdraw cash at any time without fees or penalties.
Money market funds try to maintain a price of $1 per share—and while this is almost always possible, there’s no guarantee it will happen. So investors can lose some of their principal if they sell when the share price dips.
How are money market mutual funds different from a savings account?
Money market mutual funds differ from money market accounts in a few key ways.
A money market account is a type of savings deposit account at a bank or credit union. Account holders can make deposits and withdrawals and can earn money on the account balance.
These accounts may come with debit card and check-writing privileges, though account holders may have to pay fees if they don't follow transaction requirements. Events in financial markets and the economy, such as Federal Reserve actions, can have a direct impact on money market account rates and cause yields to rise or fall. Account holders may be able to find better rates on high-yield savings accounts.
Money market accounts are also guaranteed up to $250,000 at banks that are insured by Federal Deposit Insurance Corp. The insurance protects account holders against bank failure and theft.
In contrast, money market mutual funds are not insured by the FDIC, which means investors risk losing principal if the share price ever falls. And while there are no fees to deposit or withdraw money, investors will pay a fee in the form of an expense ratio. The expense ratio subtracts from the investor's earnings. But on the plus side, money market mutual funds can only invest in short-term, high-quality instruments.
Different types of money market funds
There are three main types of money market funds, and they each have different underlying investments.
Prime money fund
A prime money market fund invests in high-quality, short-term debt securities issued by domestic and foreign entities. Some of these entities include corporations, banks, U.S. government agencies, and government-sponsored enterprises.
Government money fund
A government money market fund invests at least 99.5% of its total assets in U.S. government-backed securities, repurchase agreements tied to those securities, and cash. These securities are fully backed by the U.S. government, making them extremely safe.
Tax-exempt money fund
Tax-exempt money funds typically invest at least 80% of their total assets in short-term federal or state municipal securities. Interest earned is tax-exempt at the federal level and may be on the state level, too.
Advantages of money market funds
Money market funds may benefit individuals looking to temporarily invest money in a safe place or diversify with a more conservative approach. Some of the advantages include:
- Low risk. Money market funds typically invest in cash equivalents, making them less risky than some other investment vehicles, such as longer-term bond funds and stock mutual funds.
- Short duration. These funds have a duration of just a few months, which means they're typically subject to less interest rate risk than investments with longer maturities.
- Cost-effective. Investors won't pay fees to deposit or take out cash from a money market mutual fund. Other investments, such as stocks and exchange-traded funds (ETFs), may charge fees when buying and selling shares.
- Potential tax advantage. Money market funds that invest in tax-exempt securities, such as municipal bonds, are exempt from federal and state income taxes. Other investments, such as stocks and index funds, may incur taxes from capital gains and dividends.
- Highly liquid. Money market fund holders can withdraw cash at any time and get their money within a few business days. Treasury bills, on the other hand, are not as liquid. And savings accounts, such as money market accounts, may impose transaction limits.
- Fixed income stream. Money market funds often pay earnings in the form of monthly dividends. Some stocks, bonds, and index funds also make payments from dividends or interest earnings.
Disadvantages of money market funds
Money market funds may not be appropriate for long-term investing for a few reasons. Here are some of the drawbacks of this type of investment:
- Management fees. Management fees in the form of an expense ratio. The average money market fund charged 0.22% in 2020, which works out to $22 for every $10,000 invested.
- Low returns. Investors make a trade-off with money market funds. Compared to some investments, such as stocks, there's less risk but also lower returns.
- May lose principal. Fund managers try to keep a constant price of $1 per share, but there are no guarantees. If the share price drops below this threshold—known as "breaking the buck"—investors can lose some of their principal when they redeem their shares. The Reserve Primary Fund, which was the original money market fund, broke the buck in September 2008 during the financial crisis. This triggered a run on banks, and ultimately led to a federal bailout of the U.S. financial industry.
- No FDIC insurance. Unlike savings accounts and CDs, money market mutual funds aren't covered by FDIC insurance, which guarantees up to $250,000 per depositor. So while money market funds seek to preserve value by investing in high-quality securities, investors still risk losing money.
The bottom line
With a money market mutual fund, the investor gains access to high-quality debt securities—a plus for those who want to reduce risk. These funds are considered sound short-term investment options for the risk-averse who want higher returns than on traditional savings accounts. If you’re ready to start growing your capital, Titan is ready for you. Our team of exceptional investment analysts manage hundreds of millions of dollars, investing our clients in actively-managed, long-term strategies with an eye on massive growth potential. Through our award-winning app, you’ll ride shotgun with some of the smartest investment minds in the business. Sign-up takes minutes: get started today.
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