Money Market Funds Explained: What They Are, How They Work, Types, Pros and Cons
Money market funds, also known as money market mutual funds, are a type of low-risk, high liquidity investment. They comprise near-term, short-maturity securities, including cash, cash equivalents, Treasury funds, and certificates of deposit.
Money market funds are regulated by the US Securities and Exchange Commission. They are a popular investment option provided by mutual fund companies, banks, and brokerages.
The primary purpose of a money market fund is to offer investors flexible opportunities that carry a low level of risk. Money market mutual funds are among the least volatile and most liquid investment types.
In this guide to money market funds, we’ll explain what they are, how they work, what advantages and disadvantages they offer, and which types are available.
What Is a Money Market Fund?
If you’re new to investing or you’re considering diversifying your investment portfolio to include low-risk investments, you may be wondering what a money market fund is.
A money market fund is a type of mutual fund that enables investors to invest in liquid securities with a maturity of 13 months or less (with the exception of government funds).
These debt securities are characterized by their maturity and very low credit risk. The type of money market fund will dictate the kind of instruments held. There are three main types of money market funds in the US:
- Prime funds (also known as general purpose)
- Tax-exempt funds (also known as municipal funds)
- Government and Treasury funds
It is important to note that money market funds are not the same as money market accounts.
A money market account is a type of savings account that earns interest on deposits. MMAs are available from banks and other financial institutions and are insured by the Federal Deposit Insurance Corporation. There are benefits to investing in top-rated money market accounts, but in most cases, there are limitations that make them less flexible than other types of savings accounts.
How Do Money Market Funds Work?
Money market funds work in a similar way to typical mutual funds. They issue shares or units to investors and operate according to guidelines set by the SEC.
There are various types of debt securities and instruments that funds can invest in. These include:
- Banker’s acceptance
- Certificate of deposit
- Commercial papers
- US Treasury bills
- Repurchase agreements
Money market mutual funds offer a selection of products to investors. The net asset value is designed to stay at $1 per share. There have only been a couple of situations where the value has dropped below $1, including the financial crisis of 2008.
Excess earnings on money market funds are distributed among investors via dividends. The $1 NAV is one of the primary motivators for investors, as it facilitates regular payments from fund managers to fund holders.
The returns of the instruments contained within a money market fund are dependent on market interest rates. This means that the overall reward also fluctuates in line with changing interest rates.
Types of Money Market Funds
Funds are classified into several categories according to the maturity period and the type of investment assets.
Prime Money Market Fund
Also known as general purpose funds, prime money market funds invest in floating-rate debt and commercial papers issued or assigned by non-Treasury entities, including US government agencies or organizations and enterprises sponsored by the government, known as GSEs.
Government and Treasury Funds
Government and Treasury funds invest in cash and instruments backed by the US government, including Treasury bills, 100% collateralized repurchase agreements, Treasury bonds, and government securities.
Tax-exempt funds, also known as municipal funds, are exempt from federal taxes. In some cases, they may also be exempt from state taxes. Municipal funds can be classed as national municipal or state municipal.
Pros and Cons of Money Market Funds
Although generally safe, money market investments are not free from risk and disadvantages. If you are thinking about buying shares of money market funds, it’s wise to consider the pros and cons first.
The advantages of money market funds include:
- Very low risk: One of the main reasons money market funds are so popular. Beginners may not want to experiment with high-risk investments, while experienced investors may wish to consider money market funds as a means of diversifying their investment portfolio to manage risks.
- High liquidity: Money market funds offer high liquidity in comparison with other types of investments, which gives investors more freedom and flexibility. A liquid investment can easily be converted into cash without the investor losing money.
- Higher returns than bank accounts: Money market funds are considered a low-risk, low-return investment option, but they do offer superior returns to regular savings accounts.
- Stability: Money market funds are among the least volatile types of investment funds.
- Regulation of money market funds for added security: Money market funds are regulated by the SEC. Fund managers must comply with regulations, which enhances security and provides investors with peace of mind.
- Short-term investment options: If you’re looking for a short-term investment option that doesn’t carry a high level of risk or uncertainty, this could be an ideal solution.
- Tax benefits: In some cases, investors can benefit from tax exemption by investing in money market funds. Municipal money market funds offer a means of earning money without paying federal and/or state taxes.
The disadvantages of money market funds include:
- Not insured by the FDIC: Unlike other types of CDs and savings accounts, money market funds are not insured by the Federal Deposit Insurance Corporation. This means that there is a low risk of losing money.
- Low returns: Money market returns are usually lower than those of other investment types, as capital appreciation is limited and risks are low. More volatile investments, such as stocks and bond mutual funds, can be more profitable.
- Price fluctuation: There is a risk of price fluctuations due to changes in interest rates and other factors that influence share prices.
Who Should Consider Investing in Money Market Funds?
Money market funds are suitable for a wide range of investors, including:
- Beginners looking for safe ways to grow their money in the short term
- Investors who have a short-term investment goal
- Investors with a low risk tolerance
- Investors searching for opportunities with minimal volatility
- Experienced investors looking for low-risk strategies to diversify their portfolio
- Investors who want highly liquid instruments
- Investors who want to use the portfolio of a money market fund to offset the risks of more volatile investments, such as stocks
- Investors looking to hold their money in a relatively safe fund while they wait for other opportunities
The History of Money Market Funds
Launched in the US in the 1970s, money market funds were designed to provide a simple, safe way to invest money in securities that often offered better returns than savings accounts. Originally, these funds comprised only government bonds, but today, there is a much wider range of bonds and securities available.
Following the financial crash in 2008, the SEC introduced new measures to improve money market fund management.
In 2010, the SEC made rules more robust to enhance stability. It enforced tougher restrictions on money market portfolio holdings. In 2016, it announced further changes to regulations. Prime money market funds were required to float the NAV rather than maintain the stable value.
Today, money market funds are considered a safe investment option for beginners, as well as experienced investors who want to diversify their portfolios or hold their cash while they wait for new opportunities to come along.
How are money market funds taxed?
Money market funds are divided into two categories: taxable and tax-exempt. Municipal money market funds are exempt from federal and state taxes in some cases. Funds that are taxable are liable for regular federal and state taxes.
Are money market funds safe?
Money market funds are a low-risk investment opportunity. They are generally considered to be a safe option for investors. The target value per share is $1. The value has only dipped below this on a few occasions, and every time it has recovered quickly.
What is an example of a money market fund?
There are three types of money market funds: prime, municipal or tax-exempt, and government and Treasury. Money market funds invest in near-term debt-based securities with high liquidity and low volatility. Examples of money market fund securities and instruments include CDs, Treasury papers and bills, cash and commercial papers.
For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.
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