Money market funds are mutual funds are designed to be low-risk, liquid and short-term investments. They are normally offered by companies that have invested in other money market instruments and are almost always composed of highly rated paper. Investors can choose between municipal money funds, state-level debt funds, Treasury funds or funds that focus on private commercial money market exposure.

What Makes a Money Market?

A market can be described as a money market if it is comprised of highly liquid, short-term assets. Maturities should not exceed one year on instruments, and they can be as short as one day. This includes assets such as certificates of deposit (CDs), interbank loans, money market funds, Treasury bills (T-bills), repurchase agreements, commercial paper and short-term securities loans.

The Federal Reserve Board tracks money markets through its flow of funds survey. It is standard for money markets to account for nearly one-third of all credit in the United States.

Money Market Funds

Money market funds were developed in the 1970s to provide an opportunity to buy a “group” of securities that typically provides higher returns than interest-bearing bank accounts while assuming a substantially lower risk than a typical stock investment. The product quickly grew popular; currently, around $2.9 trillion in assets are invested in these money market funds.

Money market funds typically invest in government securities, certificates of deposit, commercial paper of companies, and other highly liquid, low-risk securities. The funds attempt to keep their net asset value (NAV) at a constant of $1 per share, so typically only their yields fluctuate. Investor losses in these vehicles are quite rare, but not impossible. A money market’s per share NAV may fall below $1 if its investments perform unusually poorly.

Unlike a money market deposit account at a bank, money market funds are not federally insured, but they are regulated by the SEC under the Investment Company Act of 1940. These regulations prohibit money market funds from acquiring any investment that is not short-term, meaning that the money market fund can receive its full principal and interest within 397 days. Money market investments must also have a minimal credit risk and be either highly rated or found comparable in quality to highly rated securities.

There are several basic types of money market funds, and each includes different kinds of investments.

U.S. Treasury Funds

As the name suggests, U.S. Treasury funds invest in treasury funds. They offer lower yields than other types of money market funds, but they also offer the lowest risk. Additionally, they are tax-exempt. Treasury funds are well-suited for investors with a low risk tolerance who want to make a percent or two more in return than they earn in an interest-yielding bank account.

U.S. Government and Agency Funds

U.S. government and agency funds invest in bonds and notes of federal government agencies, which are guaranteed by the U.S. Treasury and Congress. Some also invest in foreign markets, emerging markets and mortgage-related securities. These funds are slightly riskier than U.S. Treasury funds, but they offer slightly higher yields, as well. Like U.S. Treasury funds, they are tax-exempt.

Diversified Taxable Funds

Funds that do not focus on government paper tend to have higher expense ratios, but they have been known to return more interest income. Diversified taxable funds invest in U.S. corporations' and foreign companies' commercial paper, such as repurchase agreements. Some also invest assets in deposits issued by foreign banks. Diversified taxable funds are riskier than many other money market funds, but also have higher yields. As the name suggests, their income is taxable.

Tax-free Funds

Tax-free funds invest in short-term, tax-exempt securities of local and state governments. Naturally, these funds are exempt from federal taxes. They can be quite complex. Some of them don’t invest outside of a single state. They are also the riskiest type of mutual fund. Tax-free funds are best suited to investors in a higher tax bracket, or those who live in high-tax states. For example, T. Rowe Price offers a New York Tax-Free Money Fund (NYTXX), which attempts to build a short-term, liquid portfolio of assets that is exempt from federal, New York state and New York City income taxes. It is only one of several such New York tax-preferred money funds. Similar funds are found for California, Maryland and other high-tax states.

The Bottom Line

While money market funds are safe, their long-term returns are lower than those of bonds and substantially lower than those of stocks. As such, money market funds are typically used as a place to store cash, either by investors and institutions when they are waiting for investment opportunities, or by older investors who value safety over growth. They can also be used as an alternative to traditional savings accounts for investors in low interest rate environments, or may be included in an asset allocation simply to provide balance in the portfolio.