It’s a difficult time for investors, so they look for safe options nowadays. Money market funds are one of these low-risk investments available right now. They include a bunch of short-term debt securities to provide you a safe but meager return.
We’ll go through with the basics, such as how money market funds work. We’ll see the available types, each with its pros and cons. If you’re interested, we’ll explain how you can pick money market funds for your portfolio later.
As an investor, you need to understand every option you can find. The world economy is still in trouble, so that includes your investments. Money market funds could be one of your options to secure your finances.
Table of Contents
What are money market funds?
This is a type of mutual fund that came out in the 1970s. It offered higher returns than the bank accounts that paid interest. Some call them money market mutual funds.
These funds invest in a pool of low-risk debt securities. What’s more, they often pay dividends. Different kinds include a variety of instruments and features.
You may divide them into two kinds: taxable and tax-free. If you choose the former, you’ll have to pay state and federal taxes for any returns. You’ll have to deal with these specifically:
- Federal income tax – Dividends count as income. This is why some money market funds are subject to this kind of tax.
- Capital gains tax – You’ll have to pay these depending on how long you’ve held the fund. Please read our guide for more information.
What’s more, they often contain certain debts inside. Of course, these can differ depending on the actual fund you got. Here are some of the securities found in taxable funds:
- Agency securities
- Banker’s acceptances
- Certificates of deposit (CDs)
- Commercial papers
On the other hand, you don’t have a lot of choice for tax-free funds. These often invest in tax-exempt instruments such as municipal securities. They also give lower yields.
When investors think of money market funds, low-risk investments come to mind. Yet, there are other ways you can use these. Here are some examples:
- Fast and easy money access – You may get your funds after a few business days. After, you can put that money into an account that allows you to take it out or spend it.
- Earning dividends – Some funds let you write checks to take out money from it. Still, you should follow your provider’s rules and fees.
Types of money market funds
The two types of money market funds can be separated further. These are classified according to the securities they contain. Read below for more details:
- Treasury only – As the name suggests, 99.5% of the fund invests in US Treasury bills and cash.
- Treasury – This is also 99.5% invested in US Treasury securities and/or repurchase agreements collateralized by US Treasuries.
- Government money market fund – it’s like the previous government options. Funds from certain issuers such as Freddie Mac aren’t guaranteed by the US Treasury, though.
- Prime money market fund – Invested in different money market instruments allowed by the United States SEC. These include commercial papers, corporate notes, and others from the US and other countries.
- Municipal money market fund – it has two types: national and state. The former invests in assets exempt from federal income tax. Meanwhile, the latter has assets that have no federal or state personal income taxes.
Money market funds vs. money market account
You may have heard of money market accounts. Some think they’re the same as money market funds. However, they have a few differences. Let’s talk about money market accounts.
These are similar to savings accounts. Though it often has bigger returns than regular savings accounts. Meanwhile, money market funds contain a bunch of debt securities.
It’s easy to see why some people think they’re the same. After all, they both invest in short-term debt. They belong to what’s called the “money market.”
Also, investors use them for similar reasons. They’re often the go-to for small yet safe short-term yields. Still, they have other differences:
- FDIC Insurance – Money market account holders have insurance. If something happens, they could get $250,000. On the other hand, money market fund holders don’t have this safety net. If their fund fails, they don’t receive any amount.
- Expense ratios – This is a fee for a money market fund’s management costs. You don’t get these in money market accounts.
- Easy withdrawal – One benefit of having funds is easy to access money. Meanwhile, money market accounts only allow six electronic payments or transfers every month.
Benefits and risks of money market funds
- Security – Funds must only invest in short-term and low-risk options. This means they’re not as affected by market conditions.
- Short duration – You have to hold other investments for a few years. This exposes them to future problems in the market. You take fewer risks from money market funds since you only hold them for a few months.
- The mix of investments – Funds contains different kinds of securities. If one of them doesn’t work out, the others may make up for it.
- You’re not insured – Money market funds are low-risk, not no-risk! These contain good quality securities, but even those could fail. Once they do, you won’t get back any insurance money.
- Inflation – The low returns may not help you against rising prices. Inflation may dwarf your meager yields.
- The Fed may reduce rates – Your returns may shrink if the Federal Reserve lowers interest rates. At the time of writing, the Federal Funds rate is at 10%. If it falls to near zero, you may not like how little you earn from the fund!
- Withdrawals may stop – Your money market fund may suspend your right to take out money for seven days. During that period, the yield and share prices may drop.
- Foreign issues – If you have a fund in another country, it’s affected by issues in that area.
- Liquidity fees – Due to market conditions, the fund may charge you for selling shares.
- The fund may lose value – The share price may change over time. If you sell your shares, you may get less than what you initially paid for them.
How do I pick a money market fund?
Before starting any investment, you have to set clear goals. The kinds of assets you need will depend on it. Money market funds are great for these objectives:
- You want to set aside some cash – You may park your funds in a money market fund for a few months. Then, you can place them in other investments.
- You want to earn extra for a while – Let’s say you want to invest in a pricey asset like real estate. You may invest in several funds to build money for it.
- You want another savings option – They pay better interest than a regular bank account.
Once you’ve decided, it’s time to pick the best-performing money market funds. Check the following criteria in your choices:
- Returns – See if the fund offers great earnings. It should be more profitable than other money market funds.
- Expense – This is also known as the expense ratio. Check how much you’ll have to pay for the fund’s management. If it’s too high, the low earnings might not be worth it.
- Interest rate risk – As we said, the Fed rates affect money market funds. The effects may vary depending on your chosen fund.
Should I invest?
Money market funds alone are not a good investment. Perhaps before the pandemic, its small returns may have been worth it. However, the world’s economy is still struggling from COVID.
With so much uncertainty, you shouldn’t just rely on one type of investment. Instead, get several kinds. Other assets provide fixed income, such as:
- Bonds – These involve lending to a business or your government.
- Bond funds – They’re similar to money market funds. However, bond funds may contain debts not found in money market funds.
- Annuities – These are contracts investors make with insurance companies. They could provide a fixed income for the rest of your life!
- Stocks – Some stocks are still growing despite the pandemic. They can also give you fixed income through dividends.
Money market funds aren’t the only ones that invest in different assets. These options serve a similar function:
- Index funds – These invest in an assortment of different assets, such as stocks and bonds. Index funds try to follow a specific market index such as the S&P 500.
- Mutual funds – They’re similar to index funds except for one aspect. Instead of following an index, mutual funds try to beat them.
Sometimes, the best way to beat risk is by taking on some. The safe options like money market funds pay so little that they often can’t beat inflation.
You may want to try more volatile assets. For example, real estate is a bit risky right now. Yet, crowdfunding lets you invest with as little as $500!
Better yet, try cryptocurrencies. It’s easy to start, and you don’t need much for your first coins. The world is shifting to crypto, so perhaps you should too.
Please note that this article is for educational purposes. Do not invest in anything you don’t understand. Also, only invest money you’re willing to lose.
Learn more about money market funds
Is a money market fund a good investment?
Right now, these aren’t an ideal investment. They’re unlikely to keep up with the rapidly growing inflation across the globe.
Do money market funds pay fixed income?
Some money market funds pay dividends. That may serve as fixed income. Note that you might have to pay federal income tax for your earnings.
Can you lose money in a money market fund?
You may still lose money from a money market fund. For example, its value may fall. If you sell it, you might get less than what you originally paid for it.