What are money market funds?

Investors may find themselves with extra cash, but are unsure of what to do with it. From cryptocurrencies to cutting-edge tech stocks, the riskiest investments tend to dominate the financial headlines. However, for short-term financial goals, more conservative investments may be a better alternative.

Money market funds (MMFs) – a type of mutual fund that invests in liquid, short-term securities – are a good example of lower-risk investments. Investors may earn relatively modest returns while keeping their funds easily accessible. Plus you’re not taking on a lot of risk compared to other investments.

This article gives you an overview of MMFs, including how they work and a few situations when they may be a place to stash some cash.

What are MMFs?

MMFs are a type of mutual fund – a vehicle that pools together investments to buy a portfolio of assets, ideally making a profit for shareholders. While mutual funds may invest in a variety of assets, MMFs focus on short-term debt securities, making them relatively less risky but also less profitable over time.

MMFs typically pay out more interest than you would earn depositing your money in a savings account. However, unlike money market accounts – which are savings products offered by banks – MMFs are not insured by the Federal Deposit Insurance Corporation (FDIC), meaning they have the potential of exposing you to losses.

Types of MMFs

Like all mutual funds, you can distinguish between MMFs based on the types of assets they hold in their portfolio. MMFs may focus their investments on government securities, tax-free municipal securities or short-term debt securities issued by companies and banks.

The Securities and Exchange Commission (SEC) has different rules for MMFs depending on their main investments.

Government money market funds represent the largest share of the market. The SEC defines government money market funds as those that allocate at least 99.5% of their portfolio to “very liquid investments” including cash and government securities.

Municipal MMFs invest in debt held by states and local municipalities. The income earned from municipal MMFs typically aren’t subject to federal income tax. Depending on the mix of what bonds are owned and where the investor lives, there might be some benefits at the state tax level as well.

Last but not least, a MMF that concentrates on corporate and bank debt is called a prime fund. Prime funds are the riskiest type of MMFs and tend to generate the highest yields.

There is also a distinction between retail MMFs geared toward everyday individual investors and funds that require a large minimum investment that typically attract institutional investors.

How do MMFs work?

Like any other mutual fund, investing in a MMF can be simple. MMFs can be bought wherever you buy mutual funds. What makes government and retail MMFs unique is that they aim to maintain a net asset value (NAV) of exactly $1 per share. The fund passes on excess earnings to shareholders in the form of dividends.

Those excess earnings typically come from interest paid by the short-term debt securities that make up the fund’s portfolio, the interest rate for which fluctuates based on Federal Reserve policy decisions and market rates. For government MMFs, the interest rate will typically be similar to Treasury bills (T-bills) that mature within one year. Like other mutual funds, these trade once a day and contrast with deposit accounts, from which you can take out your money whenever you want.

The pros and cons of MMFs

MMFs generate income that tends to run slightly higher than what you’d earn on a savings deposit, except without much additional risk. They also offer high liquidity, meaning you can quickly and easily access your money if need be. As a result, this makes them a place to park your cash for short term financial goals while earning more on than you would in a deposit account.

While they may appear to be an attractive place to park your money while looking out for another opportunity, MMFs offer limited returns and have reinvestment risk, making them unsuitable for achieving long-term investment goals.

Also, the rate on a MMF changes on a daily basis, and the income earned from them shouldn’t be subject to federal income tax. For example, the rate might be 4.5% at the time of purchase; if these rates go down sharply, though, then the average interest you’ll earn on the MMF will be lower than the 4.5% at purchase. In contrast for bonds, the coupon won’t change (unless it’s a floating-rate coupon) if held to maturity.

Despite their relative safety, investing in MMFs involves certain risks. In rare instances, severely adverse market conditions may cause them to “break the buck” – falling below their intended NAV of $1 per share. They are also subject to “runs” – when investors rush to redeem their shares and withdraw their capital from the fund.

During the 2008 financial crisis, a MMF “broke the buck” and triggered a surge in redemptions. The SEC responded with new regulations to enhance the transparency and liquidity of MMFs. Furthermore, the SEC continues to monitor and make proposals to increase regulations on MMFs, particularly with Institutional Prime and tax-exempt MMFs.

The bottom line

MMFs are a lower-risk type of mutual fund offering minimal potential returns. For investors looking to make their cash work harder for them, MMFs might be an interesting option to earn a market rate while maintaining liquidity and safety. However, because of their limited capacity to help you grow your wealth, these funds are probably more suitable as a temporary parking spot for cash rather than as a long-term investment.

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