When you open a brokerage account and transfer money to it, you’ll probably notice that the money goes into a money market fund at the brokerage.
Money market funds are frequently used as a holding space for uninvested funds in your brokerage account. Still, many people don’t know precisely what a money market fund is, how they work, or what separates a good money market fund from a bad one.
What Is a Money Market Fund?
A money market fund is a type of mutual fund that people can invest in. However, there are strict restrictions on the types of investments that money market funds can hold compared to other mutual funds.
Typically, money market funds hold very short-term, secure debt securities. For example, money market funds might hold U.S. and foreign government debt and other government securities with short maturity dates.
Unlike other mutual funds, which commonly seek to increase their per-share price, the vast majority of money market funds aim to keep the price of a single share at precisely $1. Instead of increasing their per-share value, they make regular payments to shareholders, much like interest payments you get from a bank account.
Despite their functional similarity to deposit accounts at a bank, it’s important to remember that money market funds are not bank accounts and should not be confused with money market accounts. Money market funds do not receive the same insurance from the FDIC and there is technically the possibility that you can lose money invested in a money market fund, just like any other investment.
However, money market funds are among the safest investments out there. Since the first money market funds appeared in the 1970s, almost none have ever “broken the buck” and fallen below a value of $1 per share. In fact, the 2008 financial crisis was only the second time it happened, when one fund saw its per-share value fall from $1 to $0.97.
Although no investment is risk-free, money market funds are incredibly safe and most investors can rely on them to preserve their balances.
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Types of Money Market Funds
There are three main types of money market funds, differentiated by the securities they invest in.
Government money market funds primarily invest in government securities.
Treasury-only government money market funds usually have as much as 99.5% of their holdings in either cash or in U.S. Treasuries, such as T-Bills.
Treasury government money market funds also keep 99.5% of their holding in cash or government securities, but they can include either U.S. Treasuries or repurchase agreements for U.S. Treasuries — agreements that involve selling a Treasury and purchasing it back soon after for a higher price.
General government money market funds put 99.5% of their money into cash or securities issued by the government or government-sponsored enterprises. This includes organizations like Freddie Mae and Fannie Mac.
2. Prime or General Purpose
Prime or general purpose money market funds don’t have to invest solely in government securities. They can hold any eligible, dollar-denominated security, including Treasury securities, commercial papers, certificates of deposit, and other private foreign or domestic debt that is short-term.
Municipal money market funds — sometimes called tax-exempt due to their special tax treatment — are money market funds that keep at least 80% of their assets invested in municipal securities. Typically, this is short-term debt issued by state and local governments or government agencies.
Depending on the securities held by the fund, the gains on municipal money market funds can be exempted from federal or state income taxes, or both.
Advantages of Market Funds
There are many advantages to investing in money market funds.
1. Stability and Security
Money market funds are among the safest investments on the market. They hold incredibly high-quality, short-term debt, which means that they rarely lose value. In their history, money market funds have only lost value in extremely rare cases — and even then, the losses they experienced were relatively small.
When you put money into a money market fund, you can typically feel confident that it will retain its value over time.
Money market funds are highly liquid investments, functioning similarly to a bank account unlike other holdings such as stocks, bonds, and mutual funds.
You can often move funds in and out of a money market fund whenever you want without notice, making it easy to use cash in a money market fund as emergency savings.
Some brokerages even offer check writing services that you can use to access the funds in a money market fund with a checkbook.
One of the best ways to reduce risk in your portfolio is to diversify your investments. If 100% of your portfolio is invested in a single stock and that company goes bankrupt, you lose your entire portfolio. If you invest 10% of your portfolio into 10 different stocks, one company failing only costs you 10% of your portfolio.
The same logic holds true for bonds and other fixed-income securities. If you own one bond and the payer defaults, you lose all of your investment, whereas holding many bonds reduces your risk.
Money market funds hold a huge variety of securities, making it easy to diversify your portfolio while only buying shares in the money market fund.
4. Tax Benefits
Municipal money market funds invest in bonds issued by local and state governments as well as government agencies. Returns from these types of bonds often receive preferential tax treatment, such as exemption from state or federal taxes.
If you invest in a municipal money market fund you can avoid tax charges, which can improve your returns.
Drawbacks of Money Market Funds
Money market funds aren’t perfect, so you should consider these drawbacks before investing.
1. Inflation Risk
Money markets are incredibly safe investments, but that safety comes at a price. The returns offered by money market funds are very low. In some cases, you can find online savings accounts with higher yields than money market funds offered by major brokerages.
Even if the balance of your account is increasing, you may be losing out on purchasing power due to inflation. Inflation is the process by which money loses value over time.
Think about all the times your grandparents talked about buying a loaf of bread and a gallon of milk for a quarter. That doesn’t mean food was almost free back in the old days — a dollar was simply worth more, so wages and prices were smaller than they are today.
Most economists agree that reasonable inflation rates are a good thing because they encourage borrowing and spending. Still, even a low inflation rate can slowly eat away at your investment’s value, so it’s important to keep an eye on the yield offered by a money market fund and the inflation rate.
2. Credit Risk
Money market funds are as safe as investments get, but that doesn’t mean that they’re completely risk-free.
The investments held by the money market fund can fluctuate in value or one of the issuers of a security held by the fund can default and fail to repay its debts. Ultimately, the value of a share in a money market fund could fall below $1, which would mean investors lose money.
The company managing the fund could also run into financial problems. If a bank goes under, the FDIC steps in to reimburse account holders, but FDIC insurance does not apply to money market funds. If the fund manager goes under, you might not be able to recover all of your investment.
3. Liquidity Risk
Money market funds are highly liquid, but there’s no guarantee that you can withdraw as much money from the fund whenever you’d like. Fund managers have the authority to restrict people’s access to their money or to limit the amount they can withdraw in a period.
Although this is rare, when it happens, it’s typically caused by volatile or uncertain markets, meaning you could be cut off from your money when you need it most.
How to Compare Money Market Funds
If you’re considering investing in a money market fund, it’s worth comparing a few to find the best deal.
The first variable to compare between funds is their investment strategy. Government money market funds are some of the safest options, but they may offer lower returns than other types of funds. Municipal funds might be a good choice if you’re holding the shares in a taxable brokerage account and want to reduce your tax burden.
Another factor to consider is the yield offered by the money market fund. The yield is like the interest that a savings account pays. The higher the yield, the more you’ll receive in dividends each month.
It’s also worth thinking about convenience. If you already have a brokerage account, you probably already have investments in a money market fund. Most brokerage firms use their money market funds as a holding place for money you have at the brokerage but haven’t invested in other securities.
Investing in a money market fund offered by another brokerage is likely to be inconvenient, so it’s often easiest to use the one offered by your current brokerage account instead of going through the trouble of opening a new account.
Money market funds are low-risk investment options for people who want an alternative to bank accounts. Although they are not insured like bank accounts, they tend to be far safer than other investment options such as stocks and even medium- to long-term bonds.
If you’re looking for an alternative to a savings account, you might also want to consider a cash management account. These accounts do offer FDIC insurance, often more than the base $250,000 you can get from a normal bank account. They also offer good interest rates and high levels of liquidity, making them appealing to many people with large cash balances.
Would you consider investing in a money market fund? Why or why not?
Originally posted at https://www.moneycrashers.com/money-market-funds/