Money market funds are practical tools that can be included in nearly any type of investment strategy.
To determine whether and how these funds fit within your investing goals, you must first comprehend their nature.
A Money Market Fund: What Is It?
A mutual fund that only makes investments in cash and cash equivalent securities—also known as money market instruments—is known as a money market fund.
These short-term investments have excellent credit quality and are very liquid.
Typically, money market funds make investments in the following kinds of securities:
- Deposit certificates (CDs)
- Commercial paper
- Acceptances of U.S. Treasuries by Bankers
- Repurchase contracts
The fund portfolio must have a weighted average maturity (WAM) of 60 days or fewer, under Securities and Exchange Commission (SEC) regulations.
Money market funds, like other mutual funds, issue redeemable units (shares) to investors and are subject to SEC regulations.
With one difference, which has to do with its net asset value (NAV), a money market mutual fund has all the characteristics of a mutual fund.
Later on, we’ll examine this exception in more detail.
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Comparing Money Market Accounts and Funds
Despite their striking similarities, money market funds and money market accounts (MMAs) are not the same thing.
The primary distinction is that the latter are interest-earning savings accounts provided by banking institutions, with restricted transaction rights and Federal Deposit Insurance Corporation (FDIC) insurance, whilst the former are sponsored by fund firms and do not have a principal guarantee.
A money market account often offers a little lower interest rate than a CD or the total return of a money market fund, but a higher interest rate than a bank savings account.
Furthermore, while money market fund withdrawals are typically available upon request, money market accounts limit the ability to access account balances through cheque writing.
While some banks do not allow MMAs to write checks, others might permit up to six withdrawals per statement cycle.
Although they need checks to be made for a minimum amount, many money market funds allow limitless check writing.
Features That Set Money Market Funds Apart
Three factors make money market funds unique:
1. Security
These funds make investments in stable and typically secure securities.
Money market securities have short maturities and a fixed return.
Through the acquisition of debt instruments from banks, big businesses, and the government, money market funds provide a respectable return with a minimal default risk.
2. Minimal Initial Investment
The great majority of individual investors find it difficult to purchase money market assets due to their often high minimum purchase requirements.
The minimal requirements for money market funds, on the other hand, are significantly lower and even lower than those of typical mutual funds.
Consequently, investors can benefit from the safety associated with money market investments at lower thresholds thanks to money market funds.
3. Availability
Shares of money market funds are not restricted by market timing and can be purchased and sold whenever you choose.
Similar to trading money market securities, the majority of these funds allow investors to write checks and offer same-day settlement.
Comparing Taxable and Tax-Free Money Market Funds
There are two types of money market funds: taxable and tax-free.
Any returns from a taxable fund are typically subject to standard state and federal taxes if you purchase one.
U.S. Treasury securities, government agency securities, repurchase agreements, CDs, commercial paper, and bankers’ acceptances are the primary investments made by taxable funds.
Taxable money market funds can be used for a wide range of other investment kinds.
There are fewer alternatives with tax-free funds.
These funds have a lower yield and invest in short-term debt obligations issued by municipal securities, which are entities exempt from federal taxes.
You can buy tax-free funds that are free from both state and municipal taxes in certain situations, but these exemptions are more the exception than the rule.
How to Determine the Yields of Tax-Free Money Market Funds
It is crucial to determine whether the tax savings generated by the tax-free fund will be sufficient to justify its lower yield when choosing between tax and tax-free funds.
Nominally, taxable funds typically yield better returns.
However, the tax-free fund is the better option if the tax on those earnings essentially eliminates the extra return.
The yields of the two funds cannot be just compared. Rather, you must transform the tax-free yield into a taxable yield that is equal to it.
The following formula can be used to achieve this:
Taxable equivalent yield = tax-free yield / (1−marginal tax rate)
As an illustration, suppose you are in the 24% tax bracket and must decide between a 1.5% yielding taxable money market fund and a 1.3% yielding tax-free fund.
1.71% is obtained by applying the aforementioned formula to convert the tax-free yield into a taxable equivalent yield:
1−0.24 ÷ 0.013 = 0.0171
The decision is clear: Since the tax savings offer a higher yield, the tax-free money market is the best option.
The taxable equivalent yield improves with increasing tax bracket.
Risks of Money Market Funds
Every asset has limitations. Three things to consider before investing in a money market fund are:
The ratio of expenses
Money market funds incur costs, just like traditional mutual funds.
Generally poor returns will be eroded by a fund with an expense ratio that is greater than normal.
Investment Goal
A sizable holding in money market funds is inappropriate if you are a long-term investor creating a retirement fund.
These funds typically produce income that is only marginally higher than inflation, which is insufficient to create a sizeable nest egg.
Rather, money market funds have to be utilised as a tool for managing a portfolio in order to temporarily park funds or amass funds for a planned cash outflow.
Risk Elements
Money market funds are not completely risk-free, despite their relative low risk.
When the values of the derivatives that made up the majority of the Community Bankers U.S. Government Money Market Fund of Denver fell sharply in 1994, the fund found itself in hot water.
The fund was liquidated by the Securities and Exchange Commission, and all institutional investors received a meagre $0.96 on the dollar.
In a different instance, in September 2008, the Reserve Primary Fund failed.
When Lehman Brothers filed for bankruptcy, the Reserve’s own investors panicked and sold their holdings, which included hundreds of millions in short-term loans to the famous fund.
The price of the fund’s shares fell to $.97, and Reserve was eventually forced to collapse because it could not pay redemptions.
The U.S. Treasury had to intervene and guarantee other money market funds to prevent a collapse of the industry.
Although it is a remote possibility, the so-called “breaking the buck” occurs when a money market fund’s net asset value (NAV) drops below the customary $1 level it is meant to maintain, resulting in the fund’s dissolution.
(The only two failures in the history of money market funds, dating back to 1983, are Community Bankers and Reserve Primary.)
However, it serves as a warning that even conservative investments have some risk.
The Bottom Line
Make sure you learn as much as you can about a given fund, including its features, investment strategy, and how its costs stack up against similar vehicles, whether you choose to use money market funds as an investment vehicle or as a short-term holding area while you wait for the right security to purchase.
Money market funds are frequently promoted as being equivalent to cash. They’re not. It’s not an investment, and you wouldn’t want it to be.
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