Money market funds are useful vehicles that have a role to play in almost any 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.

Money market funds generally invest in such instruments as:

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

While they sound highly similar, money market funds differ from money market accounts (MMAs). The key difference: 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). A money market account usually pays a higher interest rate than a bank savings account, but a slightly lower interest rate than a CD or the total return of a money market fund.

In addition, money market accounts restrict the accessibility of account balances through check writing, while money market fund withdrawals are generally available on demand. Some 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. 

Unique Qualities of Money Market Funds

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. In contrast, 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.

Taxable vs. Tax-Free Money Market Funds

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.

Calculating Tax-Free Money Market Fund Yields

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—nominally. But if the tax on those returns effectively wipes out the additional return, the more optimal choice is the tax-free fund.

You can't just compare the two funds' yields by themselves. Instead, you need to convert the tax-free yield into an equivalent taxable yield. This can be accomplished with the following equation:

Taxable equivalent yield=Tax free yield(1marginal tax rate)\text{Taxable equivalent yield} = \frac{\text{Tax free yield}}{(1 - \text{marginal tax rate})}Taxable equivalent yield=(1marginal tax rate)Tax free yield

For example, 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 1.3%. By converting the tax-free yield into a taxable equivalent yield (using the formula above), we get 1.71%:

0.013÷(10.24)=0.01710.013 \div (1 - 0.24) = 0.01710.013÷(10.24)=0.0171

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 bracket, the better the taxable equivalent yield becomes.

Money Market Fund Risks

No asset comes without caveats. Before you invest in a money market fund, be aware of three areas of concern:

Expense Ratio

As with regular mutual funds, money market funds have expenses. A fund with a higher-than-average expense ratio is going to eat into relatively low returns.

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.

Risk Factors

Although they are relatively low-risk, money market funds are not entirely risk-free. In 1994, the Community Bankers U.S. Government Money Market Fund of Denver got in trouble when the prices of the derivatives that dominated its portfolio dropped heavily. The Securities and Exchange Commission liquidated the fund, and investors (all institutional) received only $0.94 on the dollar.

In a more recent case, the Reserve Primary Fund failed in September 2008. The prestigious fund held hundreds of millions in short-term loans to Lehman Brothers and, when that investment firm went bankrupt, a wave of panicked selling ensued among Reserve's own investors. The fund's share price dropped to $.97; unable to meet redemptions, Reserve ultimately was forced to fold. To avoid an industry meltdown, the U.S. Treasury had to step in and guarantee other money market funds.

This so-called "breaking the buck"—when a money market fund's net asset value (NAV) falls below the traditional $1 level it's supposed to maintain, leading to the fund's liquidation—is admittedly a remote possibility. (Community Bankers and Reserve Primary are the only two recorded failures in the history of money market funds, going back to 1983.) But it's a reminder that every investment carries some risk, even conservative ones. 

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 a particular fund, its characteristics, its investment strategy, and how its expenses compare to comparable vehicles. Money market funds are often touted as the same as cash. They're not. No investment is—nor would you want it to be. (For related reading, see "CPFXX, SPAXX, VMFXX: Top Government Money Market Funds")