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 objectives.

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 called money market instruments. These vehicles are very liquid short-term investments with high credit quality.

They generally include:

Securities and Exchange Commission (SEC) rules dictate the fund portfolio must maintain a weighted average maturity (WAM) of 60 days or less. 

Just like other mutual funds, money market funds issue redeemable units (shares) to investors and must follow guidelines set out by the 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 (MMAs) is the former are sponsored by fund companies and carry no guarantee of principal, while the latter are interest-earning savings accounts offered by financial institutions, with limited transaction privileges and insured by the Federal Deposit Insurance Corporation (FDIC). Money market accounts usually pay a higher interest rate than a savings account but a slightly lower interest rate than a CD or the total return of a money market fund.

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

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 stable and generally 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 that make it difficult for the vast majority of individual investors to buy. On the other hand, money market funds have substantially lower requirements that are even lower than average mutual fund minimum requirements. As a result, money market funds allow investors to take advantage of the safety related to a money market investment at lower thresholds.

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 and offer investors 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 like the housing sector, you can buy a money market fund that solely invests in Fannie Maes.

Tax-free funds 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 cases, you can purchase tax-free funds that are exempt from both state and local taxes; however, these kinds of exemptions are exceptions rather than the norm. (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. Instead, you need 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 24% 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.

Money Market Fund Risks

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

  • Expense Ratio: As with regular mutual funds, money market funds have expenses and a higher-than-average expense ratio is going to eat into relatively low returns. (To learn more, see: Stop Paying High Mutual Fund Fees.)
  • Investment Objective: If you are a long-term investor building a retirement fund, a large position in money market funds is not appropriate. On average, these funds generate income just slightly above the rate of inflation, which is not sufficient to build 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: Many investors believe money market funds are risk-free but this is not true. Since the adoption of money market funds in 1983, they've failed twice to repay an investor's full principal. In 1994, the Community Bankers Money Market Fund of Denver got in trouble and paid out only $0.96 on the dollar. The Reserve Primary Fund failed in September 2008, forcing the U.S. government to step in and guarantee other funds to avoid an industry meltdown. This so-called "breaking the buck" is still a remote possibility but could happen again. 

    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 its characteristics.

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