What Are Money Market Funds, and How Do They Work?

February 26, 2023 Beginner
Money market funds typically invest in higher-yield, short-term debt securities. Learn how they work, their pros and cons, and if they make sense for you.

Money market funds are essentially mutual funds that invest in money market instruments, such as certain short term U.S. Treasuries, municipal securities, certificates of deposit (CDs), commercial paper, repurchase agreements, and bankers' acceptances.

It's important to note that a money market fund is not the same as a money market account. A money market fund is a type of mutual fund that invests in money market instruments; hence, it's an investment product that you must directly buy or sell.

But let's back up for a moment. In case you aren't familiar with any of these terms, here's a brief explanation:

  • Money market instruments designate an assortment of highly liquid debt securities, most of which have short-term maturity dates.
  • Money market funds, on the other hand, are investment products that combine different money market instruments to pursue a diversified range of debt exposure and yield. Their objective is to earn interest with minimum risk while maintaining a net asset value (NAV) of $1 per share, although it's important to remember this can't be guaranteed. (Note: Institutionally held funds are subject to a floating NAV, meaning they might deviate from the stable $1 NAV in certain situations. Funds held by retail investors and government institutions, however, may be exempt from this floating NAV requirement. Nevertheless, they can still be subject to falling below $1.00 per share.)

What do money market funds invest in?

In general, money market funds invest in six types of securities. The money fund may invest in some or all of these security types:

  • U.S. Treasuries. Interest-paying debt securities—bills, notes, and bonds—issued by the U.S. government.
  • Municipal securities (munis). Interest-paying securities that municipal and state governments issue to finance various operations.
  • Certificate of deposit (CD). A promissory note issued by a bank that agrees to pay a fixed amount of interest in exchange for depositing cash for a specified time period.
  • Commercial paper. Short-term debt (promissory notes) issued by companies to pay liabilities that need to be met immediately; maturities typically last no longer than 270 days.
  • Repurchase agreement (repo). A short-term debt agreement in which a dealer, who sells government securities to an investor as collateral in exchange for cash, agrees to repurchase the securities, typically on the following day at a price that includes interest.
  • Bankers' acceptances. A promised future payment (similar to a post-dated check) issued and guaranteed by a bank.

You may not be as familiar with the last three asset classes—commercial paper, repos, and bankers' acceptances—as you are with the first three. No surprise: The last three are generally unavailable to retail investors. Instead, they're traded by institutions. But money market funds make them available to retail investors.

What are the types of money market funds?

Money market funds can be grouped into three general categories:

  • Government money market funds. As the name implies, these funds are limited to government securities, such as U.S. Treasuries (bonds, notes, and bills), and collateralized repos involving Treasuries. This category also includes so-called government-sponsored enterprises (GSEs), such as Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. It's important to note, however, that GSE debt is typically not guaranteed by the U.S. government.
  • Municipal money market funds. These are often called tax-exempt funds because interest on municipal securities is generally exempt from federal income tax.
  • Prime money market funds. Prime money market funds are also called general-purpose money markets because assets can be invested in any of the security types listed above.

U.S. government money market funds are typically regarded as the safest of the three, and within that category, those with a high concentration of Treasuries—with full government backing—would be exposed to a lower likelihood of default risk. 

What are the pros and cons of money market funds?

As with every investment product, money market funds have their advantages and disadvantages. It's important to assess how these opportunities and limitations align with your financial goals, investment style, and risk tolerance as you consider money market investing.

Pros

Money market funds are designed to provide steady interest income with low risk. Shares held by retail investors, although not guaranteed, seek to maintain a NAV of $1 per share.

Some money market funds, namely those invested in certain municipal securities, can provide a tax advantage at the state and federal level.

Remember: Because money market funds pool assets from multiple investors and typically invest in a wide array of investments, they can give retail investors exposure to a diversified portfolio of securities at a lower minimum investment. Some money market funds are more diversified than others, so it's important to read each fund's prospectus before investing.

Also, if you're a retail investor who wishes to invest in commercial paper, repos, or bankers' acceptances—investments typically available to institutional investors—money market funds allow you indirect exposure to these investments.

Money market funds can be relatively inexpensive to own and don't usually impose withdrawal fees. However, keep in mind that some companies charge a small annual fee or may charge a fee if the amount invested in the fund is below a minimum threshold. Also, many money market funds limit the number of times you can withdraw in a month.

Cons

Although money market funds are typically regarded by most investors as relatively safe investments, it is possible to lose money by investing in such funds. They aren't FDIC insured, nor are they guaranteed by the U.S. government or a government agency. Money market funds aren't deposits or obligations of, nor are they guaranteed by, any bank (unlike money market accounts offered by your local bank, which are typically FDIC insured). And it's important to remember that because mutual funds aren't traded during the day like stocks and exchange-traded funds, you may not have intraday access to money held in money market funds.

Another thing to consider when you invest in money market funds is that their yield may not always keep up with the rate of inflation, meaning your gains may experience erosion during periods of higher inflation. Finally, money market funds may not match the higher growth potential of stocks and other investment products that carry higher risk.

Tax-advantaged funds may pay dividends that are subject to the alternative minimum tax and, despite the name, may have tax obligations if they happen to hold investments in taxable obligations.

Like any investment, it's important to weigh the pros and cons of money market funds before investing.

Carefully consider the investment objectives, risks, charges, and expenses before investing.

Money market funds, like mutual funds, are neither FDIC insured nor guaranteed by the U.S. government or government agency and are not deposits or obligations of, or guaranteed by, any bank. There can be no assurance that these funds will be able to maintain a stable net asset value of $1 per share. It is possible to lose money by investing in money market funds. Tax-exempt funds may pay dividends that are subject to the alternative minimum tax and also may pay taxable dividends due to investments in taxable obligations.

The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund's liquidity falls below required minimums because of market conditions or other factors.
 

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