Money Market Funds: Everything You Need to Know

Money market funds in the aggregate are offering some of the highest yields seen in decades. Since there are many different types of funds in the money market space, investors need to understand the choices while considering their needs, including yield and taxation. 

Learn the basics on money market funds and how to choose the best funds for your investing needs. 

What Is a Money Market Fund? 

A money market fund is a type of mutual fund that invests in low-risk, short-term debt securities. It is designed to provide investors with a relatively safe and liquid investment option that offers competitive returns compared to traditional savings accounts. The primary objective of a money market fund is to preserve the principal investment while generating income through interest payments. 

Investors in money market funds often include individuals, corporations and institutional investors who seek a safe and short-term place to park their cash holdings. These funds are typically used for short-term cash management purposes, such as temporarily holding funds before deploying them into other investments or meeting near-term financial obligations. 

How Do Money Market Funds Work? 

Money market funds aim to maintain a stable net asset value (NAV) per share, usually set at $1, which means the value of each share remains constant. To maintain this stability, money market funds invest in instruments such as Treasury bills, certificates of deposit, commercial paper and short-term corporate debt.  

The securities held in a money market fund typically have a short maturity period, usually less than 13 months, and are considered to have a high credit quality. 

What Is the First Money Market Fund? 

The first money market fund, often considered the prototype for this type of investment, was launched under the name “The Reserve Fund” and was created by Bruce R. Bent and Henry B. R. Brown in 1971. The fund was initially designed to provide investors with a higher-yielding alternative to bank savings accounts by investing in short-term debt instruments. 

The concept of the money market fund was so successful that it quickly gained popularity and paved the way for the development of similar funds by other financial institutions. The Securities and Exchange Commission (SEC) recognized the need for regulations specific to money market funds and subsequently established guidelines to ensure their stability and investor protection. 

What Are the Types of Money Market Funds? 

There are several types of money market funds, each with its specific characteristics and investment focus. Here are some common types: 

• Government money market funds: These funds primarily invest in short-term debt securities issued by the government and government agencies. They typically focus on Treasury bills, Treasury notes and other government-backed securities.  
• Treasury money market funds: Like government funds, Treasury money market funds focus on government securities; however, they invest exclusively in U.S. Treasury securities.  
• Prime money market funds: Prime funds invest in a broader range of short-term debt securities, including commercial paper, certificates of deposit and other corporate debt instruments. These funds seek to maintain a slightly higher yield by taking on a slightly higher level of credit risk compared to government funds. Prime funds may invest in both domestic and international debt securities. 
• Tax-exempt money market funds: These funds invest in short-term debt securities issued by state and local governments, municipalities and other tax-exempt entities. The income generated by these funds is generally exempt from federal income tax and may be exempt from state and local taxes, making them attractive for investors in higher tax brackets seeking tax-efficient investments. 

Are Money Market Funds Safe Investments? 

Money market funds are generally considered safe investments, but they are not entirely risk-free. Certain types of funds may be safer than others, in terms of credit risk. For example, government and Treasury money market funds are considered safer than other types. These funds are backed by the full faith and credit of the U.S. government, making them highly secure. 

What Are the Pros and Cons of Investing in Money Market Funds? 

Money market funds offer several advantages, including stability, liquidity and competitive yields. However, there are some potential disadvantages, such as credit risk, interest rate risk and inflation risk, that investors should consider when evaluating them as an investment option.  

Here are some pros and cons of money market funds: 

Pros of Money Market Funds 

• Liquidity: Money market funds provide high levels of liquidity, allowing investors to easily access their funds. Typically, investors can make withdrawals or redeem shares on any business day, providing quick access to cash when needed. 
• Stability: Money market funds aim to maintain a stable NAV per share, usually set at $1. This stability makes them attractive for conservative investors seeking to preserve their principal investment. 
• Low risk: Money market funds invest in low-risk, short-term debt securities issued by governments, corporations or other entities with high credit quality. While they are not risk-free, they are generally considered to have lower risk compared to other investment options. 
• Diversification: Money market funds typically hold a diversified portfolio of securities, spreading the risk across multiple issuers. This diversification can help mitigate the impact of a default by any single issuer. 
• Competitive yields: Money market funds aim to provide competitive yields compared to traditional savings accounts and other low-risk investments. While the yields may not be as high as riskier investments, they offer a reasonable return for the level of risk involved. 

Cons of Money Market Funds 

• Potential for low returns: Money market funds tend to provide relatively lower returns compared to other investment options such as stocks or bonds.  
• Inflation risk: Money market funds typically produce yields that are significantly below inflation. For example, when inflation was averaging 2%-3%, most money market funds were yielding 1% or less. When inflation hit a 40-year peak of 9.1% in 2022, the highest-yielding money markets were yielding around 5%. 
• Interest rate risk: Money market funds are sensitive to changes in interest rates. If interest rates decline, the yield on new investments may decrease, affecting the fund's overall return. However, money market funds generally have shorter durations, making them less sensitive to interest rate fluctuations compared to longer-term bonds. 
• Credit risk: While money market funds aim to invest in low-risk securities, there is still a minimal risk of default by the underlying issuers. A significant default or credit event in the fund's portfolio could potentially impact its stability and the value of its shares. 
• Fees: Money market funds charge management fees and other expenses, which can reduce the overall return. It's important to compare expense ratios among different funds and consider the impact of fees on the fund's performance. 
• Regulatory changes: Money market funds are subject to regulatory oversight, and changes in regulations or market conditions can impact their operations and investor experience. For example, regulatory reforms implemented after the global financial crisis introduced additional requirements and potential restrictions on certain money market funds. 

How to Choose the Best Money Market Funds 

When choosing the best money market funds, there are several factors to consider, including yield, expenses, credit quality and fund size. In the fund selection process, investors should consider their investment goals, risk tolerance and tax considerations. 

Here are some key aspects to consider for choosing the best money market funds: 

• Yield: Evaluate the fund's historical yield, which indicates the income generated by the fund's investments. Although money market funds aim to provide competitive yields, it's essential to assess the yield relative to other funds and prevailing market conditions.  
• Expense ratio: Consider the expense ratio, which represents the fund's annual operating expenses as a percentage of its average net assets. Lower expense ratios can contribute to higher returns for investors, so compare the expense ratios of different funds.  
• Credit quality: Assess the credit quality of the fund's underlying investments. Look for funds that primarily invest in high quality, low-risk debt securities issued by reliable entities. Credit ratings provided by agencies such as Standard & Poor's, Moody's or Fitch can give you an idea of the creditworthiness of the securities held by the fund. 
• Fund size and liquidity: Larger funds generally have more stability and liquidity compared to smaller funds. Investors can evaluate fund size by comparing its assets under management to other funds with similar objectives. 
• Fund provider's reputation: Consider the reputation and track record of the fund provider. Look for established financial institutions with a history of managing money market funds and a strong reputation for stability and reliability.  

Bottom Line 

Money market funds are generally a safe way to earn higher yields than the typical bank savings account. However, these funds are not entirely risk-free. It's crucial to carefully review the prospectus and understand the specific risks associated with the various types of funds before investing in any of them.