For investors, money market funds are useful vehicles that have a role to play in the management of an investment portfolio. However, you need to understand the nature of these funds to decide if and how they fit into your investing objective.

What Is a Money Market Fund?

A money market fund is a mutual fund that invests solely in cash and cash equivalent securities, which are also often referred to as money market instruments. These investments are very liquid short-term investments with high credit quality.

They generally include:

Securities and Exchange Commission (SEC) rules dictate the average maturity of money market fund securities must be 90 days.

Just like any other mutual fund, money market funds issue redeemable units (shares) to investors and must follow guidelines set out by the Securities Exchange Commission (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

A key difference between money market funds and money market accounts is the former are sponsored by fund companies and carry no guarantee of principal, while the latter are interest-earning savings accounts with limited transaction privileges offered by financial institutions insured up to a certain limit by the Federal Deposit Insurance Corporation (FDIC). Money market accounts usually pay a higher interest rate than a passbook savings account, but generally a slightly lower interest rate than a CD or the total return of a money market fund.

Money market accounts tend to restrict the accessibility of account balances through check writing, while money market fund withdrawals are generally available on demand. Some banks may allow six withdrawals per statement cycle, while others offer no check-writing option at all. Many money market funds offer unlimited check writing, but they require checks be written for a minimum dollar amount. (For more, see: Money Market vs. Savings Accounts.)

What's So Special About These Products?

Money market funds are special for three reasons:

1. Safety

The securities in which these funds invest are by and large some of the most stable and 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, thereby making it difficult for the vast majority of individual investors to buy them. Money market funds, on the other hand, have substantially lower requirements, which are generally even lower than average mutual fund minimum requirements. As such, money market funds allow you to take advantage of the safety related to a money market investment at low investment amounts.

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. In addition, while most mutual funds have a transaction-day-plus-three (T+3) settlement date, money market funds offer investors a same-day settlement, which is similar to trading money market securities. (For related reading, see What is mutual fund timing, and why is it so bad?)

Taxable vs. Tax-Free

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 to regular 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 are partial to the housing sector, you can buy a money market fund that solely invests in Fannie Maes.

Tax-free funds, on the other hand, do 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 areas, you can purchase tax-free funds that exempt you from both state and local taxes; however, these kinds of exemptions are exceptions rather than the norm, so be sure to check out all the details before you decide to purchase one. (For related reading, see: Weighing the Tax Benefits of Municipal Securities.)

Weighing the Costs of Taxes and Lower Returns

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, but if the tax on those returns is greater than the additional return you receive in comparison to its tax-free counterpart, the more optimal choice for an investor is to purchase the tax-free fund.

You can't just compare the two yields by themselves—what you need to do is convert the tax-free yield into an equivalent taxable yield. This can be accomplished with the following formula:

Taxable Equivalent Yield = Tax-Free Yield / (1 – Marginal Tax Rate)
Example - Calculating Taxable Equivalent Yield
Let's say you are in the 28% 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 1.2%. By converting the tax-free yield into a taxable equivalent yield (using the formula above), we get 1.67%, 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 brackets, the better the taxable equivalent yield becomes.

When to Be Cautious

Before you buy a money market fund, you should be aware of three areas of concern to investors:

  • Expense Ratio: As with regular mutual funds, money market funds also have expenses, and because the returns are relatively low, a higher-than-average expense ratio is going to eat into these returns. (To learn more, see: Stop Paying High Fees.)
  • Investment Objective: If you are a long-term investor working on building a retirement fund, an overly large position in money market funds is not appropriate. Investment Company Institute statistics indicate 23% of 401(k) (and other similar) plan investments are in money market funds. While admittedly safe, an allocation of this size in this asset class is unwarranted. The returns on these funds are generally only slightly above the rate of inflation and are not sufficient to produce an adequate nest egg. Instead, money market funds should be used as a portfolio management tool to park money temporarily and/or accumulate funds for an anticipated cash outlay. (For related reading, see: Get a Short-Term Advantage in the Money Market.)
  • Risk Factors: Investors in money market funds think of these mutual funds as risk-free, but this is not an absolute given. Since the adoption of money market funds in 1983, only once has such a fund failed to repay an investor's full principal amount. In 1994, the Community Bankers Money Market Fund of Denver got in trouble and paid out only $0.96 on the dollar upon liquidation. This so-called "breaking the buck" is considered a very remote possibility, but it could happen. As such, ask your fund company what's in your money market fund and to stick to funds sponsored by the prime investment companies in the industry—they have a huge stake in maintaining a net asset value of $1 per share.

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 the fund and that it's the best one for you.

(For related reading, see: Getting to Know the Money Market.)

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.