Money Market Funds: What They Are and the Advantages and Disadvantages
November 25, 2022
Money Market Funds: What They Are and the Advantages and Disadvantages
November 25, 2022
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If you’re looking at a short-term investment time horizon and want a liquid market, meaning you can easily pull your money out if you choose to, a money market fund can be a good investment vehicle. Per the U.S. Securities and Exchange Commission (SEC), money market funds developed in the 1970s “as an option for investors to purchase a pool of securities that generally provided higher returns than interest-bearing bank accounts. Money market funds invest in high quality, short-term debt securities and pay dividends that generally reflect short-term interest rates. Many investors use money market funds to manage their cash and other short term funding needs.” Over the years, money market funds have become increasingly popular. They currently hold about $3.0 trillion in assets.
What Is a Money Market Fund?
A money market fund, also referred to as a money market mutual fund, is a savings and investment vehicle offered by brokerages, mutual fund companies, and banks. It’s generally considered less volatile compared to other investment options as the investments are made in cash and other low-risk, short-term debt securities. When you invest in a money market fund, you’re generally issued shares like you would be when buying a stock or other asset class that issues redeemable units or shares.
According to Fidelity, “The types of debt securities held by money market mutual funds are required by federal regulation to be very short in maturity and high in credit quality. All money market funds comply with industry-standard regulatory requirements regarding the quality, maturity, liquidity, and diversification of the fund’s investments.” According to Investopedia, a money market fund “invests in highly liquid, near-term instruments. These instruments include cash, cash equivalent securities, and high-credit-rating, debt-based securities with a short-term maturity (such as U.S. Treasuries).” Because money market funds are closely regulated by the SEC and must adhere to strict governmental regulations, it can make them a less risky investment than investing in mutual funds, individual stocks, or exchange-traded funds.
Types of Money Market Funds
Money market funds are generally categorized depending on the asset classes in which they’re invested. Money market funds may invest in the following:
- U.S. Treasury Securities – short-term U.S. government debt obligation backed by the Treasury Department with a maturity of one year or less
- Federal agency notes – a security issued by a government-sponsored enterprise or by a federal government department other than the U.S. Treasury
- Eurodollar deposits – bank deposit liabilities denominated in U.S. dollars but not subject to U.S. banking regulations
- Repurchase agreements – short-term government securities
- Certificates of deposit – bank-issued savings certificate with short-term maturity
- Corporate commercial paper – short-term, unsecured debt obligation that financial institutions and large corporations issue
- Municipals – securities whose interest is exempt from federal and state personal income taxes
There are three commonly recognized types of money market funds:
- Prime money market funds – a money market fund that invests in corporate commercial paper and federal agency notes (not issued by the U.S. Treasury).
- Government money market funds or Treasury funds – A money market fund that invests mainly in a combination of U.S treasury securities and repurchase agreements is categorized as a government money fund. Do note that a government money fund must invest, per Fidelity, “at least 99.5% of its total assets in cash, government securities, and repurchase agreements that are fully collateralized by cash or government securities.” A money market fund that invests in U.S. Treasury securities is referred to as a treasury fund.
- Municipal money market funds – money market funds that invest in municipals is categorized as tax-exempt money fund, as municipal securities are usually exempt from federal and state personal income taxes.
Advantages of Money Market Funds
Money market funds are considered one of the more stable investment options and less likely to experience the level of volatility or considerable swings in share price compared to other asset classes. For those with a low tolerance for risk or desiring to maintain liquid assets, money market funds may be especially attractive. Money market funds are a liquid investment, meaning to get out of your positions, all you have to do is sell your redeemable units or shares at the current price. You can also write checks and make electronic transfers out of money market fund accounts, meaning you can quickly access your money if needed.
Money market funds aim to maintain a net asset value (NAV) of $1 per share, and dividends may be paid to investors on any excess earnings generated from the portfolio holdings if share prices increase above the $1 NAV. For example, if the value of a share increases from $1 per share to $1.50 per share, 50 cents per share would be distributed to you as a dividend to maintain a NAV of $1 per share.
There are also safeguards in place if the money market fund loses its value. If the price per share goes below $1 per share, the fund must liquidate, a condition sometimes referred to as “breaking the buck,” to stop your investment from losing much of its value. Profits from a money market fund can also shield you from paying taxes if the specific fund you’re invested in is based on municipals. Usually, interest rates or profits that are earned from municipals are exempt from federal and state personal income taxes.
Disadvantages of Money Market Funds
In contrast to the similarly named money market account, money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC). Accounts insured by the FDIC are guaranteed not to lose money if the account value is under your bank’s maximum FDIC coverage. Money market funds are investment products, and there’s a risk that they can lose money. There is also no guarantee that you will earn money in a money market fund. This is called credit risk. However, a money market fund rarely drops below $1 per share. According to a report by the Federal Reserve, there are only a few examples of where this happened, most notably in 1994 when the Community Bankers U.S. Government Money Market Fund was forced to liquidate when it “broke the buck” and dipped below $1 per share.
There is also an inflation risk when investing in money market funds. Per Fidelity, “Money market mutual fund returns tend to be lower than those of more volatile investments such as typical stock and bond mutual funds, creating the risk that the rate of return may not keep pace with inflation.” Because of this, you can also lose out on greater returns when the stock market is on a bull run like we saw between 2009–2019. Money market funds can also be negatively impacted by changes in government policies, interest rates, and economic downturns.
Another disadvantage of money market funds is that you’ll not benefit from capital appreciation or the power of compounding. Remember that money market funds aim to maintain a NAV of $1 per share, so anything above $1 per share is distributed to investors instead of keeping profits in the fund and letting it appreciate and compound.
Another consideration when evaluating if a money market fund is right for you is fees. According to Forbes Advisor, “Money market funds charge fees in the form of expense ratios. The higher the expense ratio, the lower your returns—and when interest rates are low, expense ratios can really eat into your money market fund earnings,” though expense ratios have been falling in recent years. According to the Investment Company Institute’s 2022 report, Trends in the Expenses and Fees of Funds, 2021, average expense ratios for money market funds were 0.12% in 2021. This means that you’ll pay $12 for every $10,000 you have invested in a money market fund. Consult the fund’s prospectus or your bank/broker for fee information.
Investing in a money market fund can be a good choice if you’re risk-averse, looking to invest in a liquid market, or your investment time horizon is short, as these are relatively stable. However, if you’re looking for a long-term investment, e.g., greater than one year, a money market fund may not be ideal because your rate of return can be lower, and the ability to outplace inflation can be hindered compared to investing in stocks or other asset classes. Money market funds may be used as a diversification tool, so even more risk-tolerant investors may include them in some allocation in their portfolios.
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Baker, Brian. (June 9, 2022). What is a money market fund? Bankrate. https://www.bankrate.com/investing/what-is-a-money-market-fund/
Bouveret, Antoine, Martin, Antoine, and McCabe, Patrick E. (2022). Money Market Fund Vulnerabilities: A Global Perspective. Federal Reserve. https://www.federalreserve.gov/econres/feds/files/2022012pap.pdf
Fidelity. (n.d.). What are money market funds? https://www.fidelity.com/learning-center/investment-products/mutual-funds/what-are-money-market-funds
Hayes, Adam. (June 02, 2022). What Are Treasury Bills (T-Bills) and How Do They Work? Investopedia. https://www.investopedia.com/terms/t/treasurybill.asp
Investment Company Institute. (March 2022). ICI Research Perspective: Trends in the Expenses and Fees of Funds, 2021. https://www.ici.org/system/files/2022-03/per28-02_2.pdf
Segal, Troy. (April 07, 2022). Money Market Funds: What They Are, How They Work, Pros and Cons. Investopedia. https://www.investopedia.com/terms/m/money-marketfund.asp
U.S. Securities and Exchange Commission. (n.d.). Money Market Funds. https://www.sec.gov/spotlight/money-market.shtml