What are money market funds, and are they a good investment?
Editorial staff, J.P. Morgan Wealth Management
- A money market fund is a type of mutual fund that carries relatively low risk and invests in short-term debt securities.
- Depending on the type of money market fund, yields may be taxable or exempt from federal and state taxes.
- While money market funds tend to be considered a relatively low-risk investment, there are downsides to consider before deciding whether to add them to your portfolio.
Money market funds are investment vehicles that can help diversify your portfolio while also serving as a cash management solution. Because of their relatively low risk, money market funds may be appealing to those looking to invest in low-volatility securities. Whether they’re a good investment for you, though, ultimately depends on your overall investment goals.
What are money market funds?
Money market funds are mutual funds that invest in cash, cash equivalents and debt securities with short maturity terms. Compared to other types of investments, they’re characterized by their generally low volatility and low returns.Investors can choose from several types of money market funds, including the following:
- Government or Treasury money market funds: These funds invest at least 99.5% of their money in cash, U.S. government securities (including Treasury bills) or fully collateralized repurchase agreements. The income you earn is generally considered taxable.
- Municipal money market funds: Income you earn from municipal money market funds generally isn’t subject to federal taxes and in some cases may be exempt from state taxes; however, certain types of municipal securities may be subject to the federal alternative minimum tax. Investments are in short-term municipal bonds issued at the local or state level.
- Prime money market funds: Another taxable fund type, prime funds invest in short-term debt securities from banks and corporations. Other investments may include corporate notes, certificates of deposit (CDs) and cash.
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Benefits of investing in money market funds
Money market funds have several advantages. Let’s consider some of them.
Safety and stability
Because money market funds typically have some of the lowest volatility among mutual fund types, they’re often viewed as a “safer” investment option. They’re also less likely than other securities to be heavily influenced by market fluctuations.
Since 2008’s Great Recession, the U.S. Securities and Exchange Commission (SEC) has put several rules in place to make money market funds less susceptible to volatility that could negatively impact investors. Measures have included a mandate to reduce interest rate, credit and liquidity risk, as well as greater transparency in investor communications.
Liquidity and accessibility
You can liquidate assets you’re holding in a money market fund through most investment accounts. Depending on the type of investment account you’re using, though, this action could trigger taxes.
If you’re using a self-directed investing platform, you may be able to simply log in and sell your shares. If your account is managed by a broker or advisor, though, let them know you’d like to sell your shares – they’ll handle the transaction for you. Funds are generally settled daily.
Potential for higher returns compared to more conservative savings vehicles
Compared to money kept in savings accounts – including high-yield savings accounts – money market funds can offer the potential for higher returns. The interest rate offered on a savings account is set by the bank where the account is located. Comparatively, the returns you may earn with a money market fund are typically based on a variety of factors – including interest rates, the securities held in the fund and market conditions, among others.
Potential tax advantages
Money market funds also have some potential tax advantages:
- Tax-exempt status: Some money market funds invest in municipal securities, which are often exempt from federal income tax. In some cases, these securities may even be exempt from state and local taxes.
- Capital gains: Money market funds typically aim to maintain a stable net asset value (NAV) – usually $1 per share – which means they generally do not trigger capital gains. This can be beneficial for investors looking to minimize taxable events.
- Low turnover: Money market funds typically have low turnover rates (the frequency with which they buy and sell investments). This may lead to fewer taxable events compared to other types of mutual funds.
Risks and drawbacks of money market funds
Like all investment vehicles, money market funds come with certain risks and disadvantages.
Interest rate risk
While the short-term duration of the securities in money market funds may help preserve the value of the money you’ve invested, shifting interest rates can nonetheless impact the amount you earn. Even relatively stable, low-risk investments can be affected by market changes.
Inflation risk
The lower-risk, lower-reward nature of money market funds may be the right investment choice for some, especially investors with a low tolerance for risk or those who are approaching retirement. If your returns aren’t at least keeping pace with inflation, though, then this type of investment might not be the best use of your money.
Lower return potential
While many investors seek out money market funds for their stability, it’s important to weigh the implications of an investment that offers lower return potential. This is especially true given the fees associated with some money market funds, which can eat into your returns.
Fees and expenses
Pay attention to a money market fund’s expense ratio. This is the yearly management fee typically calculated as a percentage of your overall investment. Some money market funds may also impose liquidity fees when investors sell shares. It’s critical that you consider associated fees and expenses when investing in a money market fund, since your returns may be lower than those of other investment instruments.
Lack of FDIC insurance
Money market funds – unlike money market accounts or savings accounts offered at banks – are not insured by the Federal Deposit Insurance Corporation (FDIC). They are, however, protected by the Securities Investor Protection Corporation (SIPC).
Comparing money market funds to other investment options
Money market funds are just one of many investment options available to retail investors. Every investment option has advantages and disadvantages, and you may want to consider several types for a well-rounded portfolio.
Let’s see how money market funds compare to other financial vehicles.
Money market funds vs. savings accounts
Savings accounts are deposit accounts offered at banks and credit unions, and they’re typically insured up to $250,000 per depositor, per bank by the FDIC or the National Credit Union Administration (NCUA). Some savings accounts may come with fees, and they tend to offer a lower rate of return compared to money market funds.
Money market funds are held at brokerages. While they may be protected by SIPC insurance, they are not insured by the FDIC.
Money market funds vs. bonds
Bonds are essentially loans made to government entities or companies that pay a fixed rate of interest to investors. Both bonds and money market funds invest in debt-based instruments and are considered lower risk than some other investment types. Compared to money market funds, however, bonds may have longer maturities and come with slightly higher risk – but also may have the potential for higher returns.
Money market funds vs. stocks
Stock prices are usually influenced by overall market conditions, industry trends and company performance, among other factors. Stocks may be riskier and more volatile than money market funds, but they offer the potential for higher returns. Investors can purchase individual stocks, or they can purchase mutual funds or exchange-traded funds (ETFs) that hold stocks. In terms of financial goals, investors typically invest in stocks to grow their wealth and money market funds to preserve it.
Who should consider investing in money market funds?
Money market funds may be best suited for investors who have a low risk tolerance or don’t have the appetite for high volatility. Money market funds can also be an option for those looking to diversify their investment portfolio against other types of securities. For example, if your current portfolio consists of high-growth stocks, buying shares of money market funds could help offset the higher risk associated with your equity investments.
Since money market funds tend to offer more stability, they can be a solid short-term investment option. Your emergency fund, for instance, might net higher returns in a money market fund than in a traditional savings account. Plus, money market funds are fairly liquid, so you can access money as needed (though there may be tax implications for doing so).
Alternatively, you could keep cash in a money market fund as you work toward a significant financial goal, such as purchasing a home.
As you consider money market funds and the role they may play in your broader financial portfolio, make sure to weigh their risks and downsides, too.
How to choose the right money market fund
The right money market fund for you depends on your financial goals. Those looking to balance stability with the potential for slightly higher returns might opt for prime funds over U.S. government and Treasury funds, for example.
If you’re interested in potentially tax-free earnings, municipal funds may be a good choice, especially if you intend to hold the funds in a taxable brokerage account.
Other factors to consider when deciding among money market funds include one-time buying or selling fees, expense ratios (or other annual fees) and the fund’s performance history.
Lastly, not all investment accounts offer the same funds. If you already have an investment account, check which funds are available, then consider whether any of them align with your financial goals. Otherwise, you may need to open another investment account to access the funds you’d like to invest in.
The bottom line
Money market funds can be a useful way to preserve your wealth or diversify your portfolio as they may offer low volatility and some potential tax advantages. Money market funds are not without risk, though, and may not be the best choice if you’re looking to hedge against inflation or grow your wealth long term.
Whether you’re looking for an account to house your emergency fund, store cash for a short-term financial goal or add more stability to your investment portfolio, it’s important to research and choose money market funds that will help advance your specific goals.
Frequently asked questions about investing in money market funds
No, money market funds – which are purchased through a brokerage – are not insured by the Federal Deposit Insurance Corporation (FDIC). The Securities Investor Protection Corporation (SIPC) may provide insurance protection, though it depends on your account type and circumstances.
While money market funds are generally low in volatility, their value can still fluctuate with market conditions. This means investors can lose money, although losses with money market funds are typically smaller than with more volatile securities, such as stocks and bonds.
Because they’re considered a “safer” investment option, money market funds may be especially appealing during a recession (or in the lead-up to a recession). It’s important for investors to note, however, that comparatively low volatility and greater stability don’t translate to zero risk – money market fund yields can still go down.
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Editorial staff, J.P. Morgan Wealth Management
