Money market funds are a type of mutual fund that includes short-term debt securities. Money market funds are highly liquid and known for being a low-risk investing strategy used primarily by those who want to generate income in the short term rather than wait out a long-term investment.
What makes up the debt securities in a money market fund? Money market funds invest in certificates of deposit, commercial papers, and short-term debt, such as U.S. Treasury bills, cash, and cash equivalents.
How do money market funds work?
The first thing to know about money market funds is they're short-term. The Securities and Exchange Commission requires money market funds to invest in securities with maturities of no more than 13 months and, in the case of government securities, 25 months at the most. The average maturity of the assets in a fund must be 60 days to comply with SEC regulations. The SEC imposes these regulations to maintain a high liquidity rate in money market funds.
A money market fund is sometimes referred to as a money market mutual fund because they're fixed income mutual funds. Mutual funds are similar to money market funds; you can buy shares from a pool of assets in the fund for efficient diversification of your portfolio. While money market funds focus on short-term debt assets, mutual funds have a variety of stocks, including investments in growth stocks, a large-cap stock, small-cap stock, and some funds are focused on specific sectors.
In general, mutual funds present more volatility and less liquidity. For example, growth stock mutual funds tend to be riskier because they invest in companies with high growth potential whose past performance hasn't necessarily been stable.
What are the pros and cons of investing in money market funds?
Like any investment strategy, money market funds are never perfect; there are still downsides you should be aware of when considering utilizing money market funds.
- A high rate of liquidity
- Potentially higher returns than a traditional savings account
- Some money market funds are tax exempt
- Low returns will not help you build wealth over time
- You could miss out on investment opportunities with higher returns
- Not insured by the Federal Deposit Insurance Corporation
- If you’re looking to find investment opportunities for income, money market funds may not have high returns that fit your objectives
What are the different types of money market funds?
If you’re wondering where to invest with a money market mutual fund, various options are available.
As you can probably guess, treasury money market funds invest in U.S. Treasury bonds, bills, and notes.
Government money market funds
Government money funds invest in cash, government securities, and repurchase agreements.
Prime money market funds
Also called a General Purpose fund, this type of fund comprises non-Treasury securities that are floating-rate debt and paper assets issued by corporations, government agencies, or government-sponsored enterprises.
Any eligible asset can be in a prime money fund, including government securities and treasury securities. Unlike government and retail funds, institutional prime money market funds float their net asset value per SEC regulations.
Tax-exempt money market funds
A typical investment for a tax-exempt fund is a municipal bond or other municipal securities. Tax-exempt funds can also be eligible for state and federal income tax exemptions.
Is a money market fund like a savings account?
Money market funds are not savings accounts, and it can be easy to confuse a money market fund with a money market account. A money market account (MMA) is similar to traditional savings account that you open with your bank. Unlike money market funds, with a savings account or MMA, the money in your account is insured by the Federal Deposit Insurance Corporation.
Compared to savings accounts, money market funds are more reactive to market interest rates, which allows them to have higher yields.
While you open traditional savings accounts at a bank or credit union, you can invest in a money market fund through either your bank, an investment company, or a brokerage firm.
The main risk of a money market fund is that, unlike with a savings account, your money is not FDIC-insured.
Why do people invest in money market funds?
There are several reasons people choose money market funds as an investment strategy.
If you are saving money for a big purchase, you could put the money in a money market fund to earn more interest than it would in your bank account, and as it's highly liquid, you can withdraw whenever you like.
The Federal Reserve plays a role in the returns you see on a money market fund, as the money market rate is driven by interest rates set by the Federal Reserve.
Another reason a person may choose to invest in a money market fund is because they want to protect their money while still earning interest. In general, money market funds beat saving accounts' interest rates but present less volatility than other investment options.
Money market funds also have a target net asset value of $1 per share. The $1 NAV forces fund managers to pay investors regularly, generating consistent low-risk income for their investment. Any extra profit the fund makes is paid to investors in dividends, who can either take the dividend as cash for extra money or reinvest it into more shares.
If you're wondering how to invest in a money market mutual fund, it's pretty simple. You can do so through a brokerage account, and some funds will have a minimum investment, while others will not. Remember to check the fund's expense ratio, as this will come out of your returns from your investment.
The bottom line
Money market funds are a type of mutual fund where you own several shares out of a pool of investments, except the assets are in debt securities. They're considered low-risk because they consist of high-quality debt securities, a plus if you want to earn returns on your money without investing in a potentially riskier option like the stock market.
Money market funds are considered solid short-term investment options for the risk-averse who want to beat returns on their traditional savings account.