Investors with a focus on the preservation of capital often seek out fixed-income solutions such as government or low-risk municipal bonds, preferred stocks, traditional bank savings products, or money market mutual funds. Each of these investment vehicles provides a degree of safety from otherwise volatile securities markets in addition to a potential stream of fixed income. Although each strategy has its own merits and drawbacks, a money market fund is a popular choice among risk-averse investors. Read on to find out more about this kind of investment and how you can benefit from these putting your money into this product.
- Money market funds invest in highly liquid securities like cash, cash equivalents, and high-rated debt-based securities.
- These funds offer investors liquidity because they're invested in securities with short-term maturities—usually 13 months or less.
- Because they only invest in highly rated securities, money market funds offer a high degree of safety.
- Money market funds also offer investors higher yields than traditional savings accounts.
What Is a Money Market Fund?
A money market fund is a type of mutual fund. It invests in highly liquid vehicles such as cash, cash equivalents, and high-rated debt-based securities. These securities tend to have short-term maturities—usually less than 13 months. Many money market funds hold securities like commercial paper and U.S. Treasury bills.
Investors purchase units or shares of a money market fund from a mutual fund company or through a broker. Just like other mutual funds, there may be a minimum initial investment amount required to take part in a money market fund. They also come with an expense ratio. This fee is calculated as a total percentage of the fund's asset which covers its administrative and operating expenses.
Don't confuse money market funds with money market accounts (MMAs). Although they may sound alike, they are different. A money market account is a savings account offered by traditional financial institutions, allowing the account holder to earn interest on the average balance. Because they are intended to act as a savings vehicle, MMAs allow investors limited withdrawals. These accounts are insured by the Federal Deposit Insurance Corporation (FDIC), while money market funds are not.
Types of Money Market Funds
Money market funds are divided into different categories depending on their attributes including their maturities and the classes of securities. For instance, government money market funds invest the majority of their assets in cash and government securities. Treasury funds invest in U.S. Treasury bills, bonds, and notes. Another type of money market fund is the tax-exempt fund. These types of funds invest primarily in vehicles that are exempt from federal taxes such as municipal bonds.
Benefits of Money Market Funds
A money market fund provides investors with an array of benefits that you may not find with other investments. The most common are noted below.
Money market mutual funds provide investors with liquidity. That's because these funds are invested in securities that mature in short periods of time and can be liquidated for cash. Fund managers invest pooled investor dollars into money market securities including bank certificates of deposit (CDs), federal agency notes, high-grade commercial paper, or government treasury issues such as T-bills.
Investors who want to park their money in a relatively safe investment may want to consider money market funds. The Securities and Exchange Commission (SEC) mandates that only securities with the highest credit ratings are available to purchase in money market funds, creating a degree of safety for investors not found in other fixed-income investments. This also helps set them apart from other investments such as stocks which are characterized by a higher degree of volatility.
In addition to safety and liquidity, money market funds offer the potential for higher yields than conventional cash equivalents such as savings or money market accounts from a bank or credit union. The objective of a money market fund it to keep its net asset value (NAV) steadily at $1, resulting in no growth of principal. Despite this, money market funds provide investors slightly higher yields than conventional cash equivalents over time because fund managers can diversify the underlying investments.
Although they're considered relatively safe investments, money market funds also come with inherent risks including inflation, credit, and interest rate risks.
A Word on Risks
Even though they're considered a primarily safe place to put your cash, money market funds do come with their own inherent risks—just like any other investment. A few things investors may want to consider are:
- Inflation Risk: This risk occurs when the cash flows from a money market fund drop because of inflation. In other words, inflation cuts down how the money market fund performs.
- Credit Risk: Because they aren't insured by the FDIC like savings accounts and CDs, there's no guarantee that you won't lose your money.
- Interest Rate Risk: This is the risk associated with fluctuating interest rates. Yields share an inverse relationship with interest rates, so when interest rates rise, yields drop and vice versa.