What Are Money Market Funds?

Money market funds are a type of mutual fund that invests in highly-rated, short-term debt securities. They generate income but little if any capital appreciation. Money market funds were established in the 1970s to provide a slightly higher-yielding alternative to interest-bearing bank accounts.

Money market investing typically carries a low single-digit return. When compared to stocks or corporate debt issues, the risk to principal is generally quite low. However, investors need to weigh several pros and cons when it comes to money market funds.

Advantages of Money Market Funds

Low Risk and Short Duration

When the stock market is extremely volatile, and investors aren't sure where to invest their money, the money market can be a safe haven for it while they decide where to put it to use. Why? As stated above, money market funds are often considered less risky than their stock and bond counterparts.

That's because these types of funds typically invest in low-risk vehicles such as certificates of deposit (CDs), Treasury bills (T-Bills), and short-term commercial paper.

Plus, the short durations of these securities limit a money market fund's sensitivity to interest rate risk.

And even though the money market often generates a low single-digit return for investors, in a volatile or down market, that can be quite attractive.

Diversification

As with most mutual funds, a money market fund offers instant diversification among a range of securities. Investors don't have to select and invest in various money market securities individually. Diversification is an important safeguard for every portfolio.

Stability and Security

A money market fund is one of the least volatile types of investment available. This characteristic can be useful in offsetting the greater volatility of stock and bond investments you may have in your portfolio. In addition, they give you a secure, short-term investment option when no other is feasible.

High Liquidity

Money market funds generally don't invest in securities that trade minuscule volumes or have little following. Rather, they primarily invest in entities and/or securities in fairly high demand (such as T-bills and short-term T-bonds). This means they tend to be very liquid; investors can buy and sell them with comparative ease.

Contrast this to, say, shares of a small-cap Chinese biotech company. In some cases, those shares may have limited investor interest. This means that getting into and out of such an investment could be difficult if the market were in a tailspin.

Potential Tax Efficiency

Investors in money market funds may find that the interest payments from some fund investments are exempt from federal and, potentially, state income taxes.

Disadvantages of Money Market Funds

Inflation Risk

If an investor is generating a 3% return from their money market fund, but the rate of inflation is humming along at 4%, they are essentially losing purchasing power each year.

Expenses Can Take a Toll

When investors are earning only 2% or 3% from a money market fund, even small annual fees can eat up a substantial chunk of the profit. This may make it even more difficult for money market investors to keep pace with inflation.

Depending on the fund, fees can vary in their negative impact on returns. If, for example, an individual maintains $5,000 in a money market fund that yields 3% annually and is charged $30 in fees, the total return can be impacted quite dramatically.

• $5,000 x 3% = $150 total yield
• $150 - $30 in fees = $120 profit

The $30 in fees represents 20% of the total yield, a large deduction that considerably reduces the final profit. The above amount also does not factor in any tax liabilities that may be generated if the transaction occurs outside of a retirement account.

No Federal Insurance Protection

A money market account opened at a bank is typically insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor. However, money market funds are not insured by the FDIC—but the Securities Investor Protection Corporation (SIPC) provides some degree of financial protection for investors.

For instance, if an investor were to maintain a $20,000 money market account with a bank and the bank were to go belly up, the investor would likely be made whole again through this FDIC coverage. On the other hand, if a money market fund were to collapse, the investor could lose some or all of their money because the SIPC only replaces the investments when possible.

The 2008 financial crisis took a lot of the shine off the stellar reputation that money market funds had enjoyed. A large money market fund broke the buck—its shares fell below $1.00—triggering a run on the whole money market industry. Since then, the industry has worked with the Securities and Exchange Commission (SEC) to introduce stress tests and other measures to increase resiliency and repair some of the reputational damage.

Risk of Higher Yields

While money market funds generally invest in government securities and other vehicles that are considered safe relative to investments such as stocks and bonds, fund managers may decide to take some greater risks to obtain higher yields for their investors.

For example, to try to capture another tenth of a percentage point of return, the fund may invest in bonds or commercial paper that carry additional risk. Depending on your investment objectives and time horizon, investing in the highest-yielding money market fund may not always be the smartest move, given this additional risk. Remember, the return a fund has posted in a previous year is not necessarily an indication of what it may generate in a future year.

Low Returns Mean Lost Opportunity

Over time, common stocks have returned about 8% to 10% on average (including data from recessionary periods). By investing in a money market fund, which may often yield just 2% or 3% due to the fixed income nature of its investments, an investor may be missing out on an opportunity for a better rate of return. This can have a tremendous impact on an individual's ability to build wealth over time.

The Bottom Line

As with any other investment, money market funds have pros and cons, which should be considered carefully before buying.

While money market funds aren't ideal for long-term investing due to their low returns and lack of capital appreciation, they offer a stable, secure investment option for individuals looking to invest for the short term.

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