Investors interested in the money market can access it most easily through money market mutual funds, but these vehicles do not let smaller investors off the hook when it comes to having a rudimentary understanding of the Treasury bills, commercial paper, bankers' acceptances, repurchase agreements, and certificates of deposit (CDs) that make up the bulk of money market mutual fund portfolios. In this article, we'll show you how money market funds work, and how they can benefit you. But first, a key delineation in order to pre-empt potential confusion.
- A money market mutual fund (MMF) is a type of mutual fund that invests in high-quality, short-term debt instruments, cash, and cash equivalents.
- Though not exactly as safe as cash, money market funds are considered extremely low-risk on the investment spectrum, and thus carries close to the risk-free rate of return.
- A money market fund generates income (taxable or tax-free, depending on its portfolio), but little capital appreciation.
- Money market funds invest in a variety of similar instruments while money market accounts exist in a single offering that is held at a bank or credit union and insured by the FDIC.
Money Market Funds vs. Money Market Accounts
Unlike cash and even typical certificates of deposit (CDs), money market mutual funds are not insured by the Federal Deposit Insurance Corporation (FDIC). There is always a risk, though extremely small, that the investor could lose money. Put another way, the crucial difference between money market funds and money market accounts is that the former is sponsored by fund companies and carry no guarantee of principal, while the latter are interest-earning savings accounts which offer limited transaction privileges, and which are offered by financial institutions insured up to a certain limit.
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 also tend to restrict the accessibility of account balances through check writing, while money market fund withdrawals are typically available on demand.
Money market funds are sometimes called "money funds" or "money market mutual funds," should therefore not be confused with the similar sounding money market deposit accounts offered by banks in the U.S. The major difference is that money market funds are assets held by a brokerage, or possibly a bank, whereas money market deposit accounts are liabilities for a bank, which can invest the money at its discretion - and potentially in (riskier) investments other than money market securities. In a money market fund, investors are buying securities and the brokerage is holding them. In a money market deposit account, investors are depositing money in the bank and the bank is investing it for itself and paying the investor the agreed-upon return.
Purpose of Money Market Mutual Funds for Investors
There are three instances when money market mutual funds (MMFs), because of their liquidity, are particularly suitable investments.
- Money market mutual funds offer a convenient parking place for cash reserves when an investor is not quite ready to make an investment or is anticipating a near-term cash outlay for a non-investment purpose. Money market mutual funds offer ultimate safety and liquidity. This means that investors will have an expected sum of cash at the very moment that they need it.
- An investor holding a basket of mutual funds from a single fund company may occasionally want to transfer assets from one fund to another. If, however, the investor wants to sell a fund before deciding on another fund to purchase, a money market mutual fund offered by the same fund company may be a good place to park the sale proceeds. Then, at the appropriate time, the investor may exchange his or her money market mutual fund holdings for shares of the other funds in the fund family.
- To benefit their clients, brokerage firms regularly use money market mutual funds to provide cash management services. Putting a client's dormant cash into money market mutual funds will earn the client an extra percentage point (or two) in annual returns above those earned by other possible investments.
Operational Details of Money Market Mutual Funds
Money market mutual funds are designed to offer features suited specifically to the needs of small investors. Minimum initial investments generally range from $500 to $5,000.
You can purchase shares in money market mutual funds directly from brokerage companies or mutual fund firms, just as you would purchase shares in a stock or equity mutual fund. As investment advisors, some banks also sell money market funds and some even have their own proprietary funds that offer money market investment opportunities.
Money market mutual funds also offer some simplified withdrawal features that are more generally associated with bank or trust accounts. For example, money market funds allow investors to withdraw assets by writing checks, with a typical minimum amount of $500 per check. If the investor does not want to write a check as a means of withdrawing funds, he or she can easily redeem shares by requesting payment by mail or by remittance via wire transfer to his or her bank account.
Categories of Money Market Mutual Funds
Money market mutual funds may contain a specific type of money market security or a combination of securities across a wide spectrum:
- One particular type of fund limits its asset purchases to U.S. Treasury securities,
- Another class of money market funds purchases both U.S. government securities and investments in various government-sponsored enterprises (GSEs),
- The third and largest class of money market mutual funds invests in a variety of money market securities that offer the highest degree of security.
Another important categorization for money market mutual funds relates to their taxable or tax-exempt status. Taxable funds invest in securities such as Treasury bills and commercial paper, the interest income on which is subject to federal taxation. Tax-exempt funds invest exclusively in securities issued by state and local governments and therefore exempt from federal taxation. Tax-exempt funds generally appeal to investors in higher federal tax brackets, who are seeking tax savings on the overall interest income generated by their portfolios.
Tax-exempt money market mutual funds have the potential to offer a triple-whammy tax reprieve for some investors! Some tax-exempt funds purchase only securities issued by governments within a particular state. If an investor can find such a fund for his or her home state, that investor can earn interest income that is exempt from federal, state, and perhaps even local income taxes.
Cash vs. Money Market Funds
Most analysts treat money market accounts like cash. When calculating financial ratios, money market securities and fund balances are added to cash balances. This is because the financial instruments that make up money market funds are considered highly liquid, meaning that they can be converted into cash quickly. In addition to being highly liquid, money market funds exhibit less volatility and are less prone to market fluctuations and interest rate risk than other investments.
The target par value of a share of most money market mutual funds.
Money market funds seek stability and security with the goal of never losing money and keeping net asset value (NAV) at $1. This one-buck NAV baseline gives rise to the phrase "break the buck," meaning that if the value falls below the $1 NAV level, some of the original investment is gone and investors will lose money.
This only happens very rarely, but because money market funds are not FDIC-insured, they can lose money. For instance, at the height of the 2008 market crash, several money market funds traded for less than $1.00 per share. The day after Lehman Brothers Holdings Inc. filed for bankruptcy, one money market fund fell to 97 cents after writing off the debt it owned that was issued by Lehman. This created the potential for a bank run in money markets as there was fear that more funds would break the buck.
The Bottom Line
Just as equity and fixed-income mutual funds have greatly simplified the world of investing, money market mutual funds have made money market investing accessible to individual retail investors. Money market mutual funds are among the safest and most liquid generally available financial instruments. Moreover, money market funds offer modest initial investment requirements and provide simple procedures for withdrawing funds by check or transfer to a bank account. Finally, if they choose carefully, purchasers of certain tax-exempt money market funds may also enjoy relief from federal, state, and even local taxes.