What are money market funds?
E*TRADE Capital Management, in collaboration with Morgan Stanley Wealth Management03/24/22
Summary: These funds may provide a lower-risk, liquid vehicle for short-term investors.
A money market mutual fund—also called a money market fund—is a type of fund that invests in high-quality, short-term debt instruments including US government securities, municipal securities, and other securities, such as commercial paper, certificates of deposit (CDs), and repurchase agreements (repos).
Money market funds pay dividends (referred to as yield) that typically reflect short-term interest rates, which in recent years have been hovering near zero percent but can increase as the Federal Reserve raises its benchmark federal funds rate. Unlike most other mutual funds or exchange-traded funds, money market funds aren’t designed to generate capital gains—the yield is the only return on the investment.
Some money market funds seek to maintain a $1 net asset value (NAV), which represents the per-share value of a fund’s assets minus its liabilities. Others have “floating” NAVs, meaning their share price can fluctuate.
Types of money market funds
By law, money market funds can only invest in securities with short maturities (typically 13 months or less). The securities in which they invest, however, can vary slightly. Funds often fall into three main categories:
- Government: Invest 99.5% or more of the fund’s total assets in cash, US government securities, or repurchase agreements collateralized by government securities.
- Municipal: Invest primarily in municipal bonds, meaning the yield is typically exempt from federal income taxes.
- Prime: Invest in a variety of taxable short-term corporate and bank debt securities, as well as commercial paper and repos, among other securities.
Money market funds are governed by strict maturity, credit quality, and diversification requirements, making them a lower-risk, liquid choice for investors who may be looking for an alternative to holding cash. Investors can generally sell their shares back to a money market fund on any business day at the NAV.
Additionally, some municipal money market funds can offer advantages in taxable brokerage accounts, since income may be exempt from federal income taxes.
Though rare, there have been instances where money market funds dipped below their $1 NAV, resulting in investors losing part of the principal value of their investment (referred to as "breaking the buck”). Money market funds with floating share prices can also lose value.
Money market funds may impose liquidity fees or redemption restrictions during times of market stress.
It’s important to note that money market funds are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency the way CDs and other bank deposits are.
Inflation is another consideration since the yield earned from money market funds is limited. In the longer term, returns likely won’t keep pace with the rate of inflation.
How to evaluate money market funds
When evaluating money market funds, investors may find themselves asking, “Should I just invest in the fund with the highest yield?” The short answer is no. There are many factors to consider in addition to the yield and historical performance.
For instance, the net expense ratio reflects the percentage of a fund’s assets that goes toward operating expenses and management fees. Investors may also want to pay attention to the initial investment minimum, which for retail funds can range from a few hundred dollars to several thousand dollars.
Bottom line: Money market funds are lower-risk investments that can offer liquidity but limited return potential. Still, for investors with short time horizons, money market funds can provide an option where capital preservation is the primary objective. Since all money market funds are different, investors should consider a fund’s characteristics and its prospectus to make sure it aligns with their individual financial goals.