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 normally 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 a number of pros and cons when it comes to money market funds.
In this article, we'll take a look at these advantages and disadvantages.
Key Takeaways
- Money market investing can be advantageous if you need a relatively safe place to park cash in the short term or if you're diversifying a growth portfolio.
- Some disadvantages are low returns, a loss of purchasing power, and the lack of FDIC insurance.
- A money market fund can be ideal in some situations and potentially unwise in others.
- If you're in your 20s or 30s, you should invest in investments with greater growth opportunities in order to build your nest egg.
- If you're close to or in retirement and you'll need some of your money soon, a money market fund can make sense.
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 to have less risk 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 limits 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 that 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 mostly invest in entities and/or securities that are in fairly high demand (such as T-bills and short-term T-bonds). This meansthey tend to be very liquid; investors can buyand sell them with comparative ease.
Contrast this to, say, shares of a small-cap Chinesebiotech company. In some cases, those shares may have limited 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.
Over time, money market investing can actually make a person poorer in the sense that the income that they earn may not keep pace with the rising cost of living.
Disadvantages of Money Market Funds
Inflation Risk
If an investor is generating a 3% return from their money market fund, but inflation is humming along at 4%, the investor essentially is 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 the individual 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 were to take place 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.
As a financial investment, money market funds may be considered a comparatively safe place to invest money. But, as with any investment, there is still an element of risk that all investors should be aware of.
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 insurance coverage. On the other hand, if a money market fund were to do the same thing, the investor could lose some or all of their money.
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 fundmay 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.
What Is in a Money Market Fund?
A money market fund is a type of mutual fund that invests in highly liquid, low risk short-term securities. As such, you'll typically find short-term Treasuries, other government securities, CDs, and commercial paper listed as holdings.
Is a Money Market Account the Same As a Money Market Fund?
No. A money market account is an interest-bearing account that's offered by a financial institution such as a bank (as an alternative to a potentially lower-paying savings account). A money market fund is an investment sponsored by a mutual fund company.
Does the U.S. Government Provide Insurance for Money Market Funds?
No, it doesn't. Nor does it do so for any other type of mutual fund. Money market funds are investments, with no guarantee of a return or principal protection. You can lose money with a money market fund investment.
The Bottom Line
As with any other investment, money market funds have their pros and cons and these 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 who are looking to invest for the short-term.
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As a financial expert with a deep understanding of investment instruments, particularly money market funds, let me delve into the concepts discussed in the article and provide additional insights to bolster your understanding of this financial instrument.
1. Money Market Funds Overview: Money market funds are a type of mutual fund that primarily invests in highly-rated, short-term debt securities. These funds were introduced in the 1970s to offer a slightly higher-yielding alternative to interest-bearing bank accounts.
2. Low Risk and Short Duration: Money market funds are often considered low-risk due to their investments in low-risk vehicles such as certificates of deposit (CDs), Treasury bills (T-Bills), and short-term commercial paper. The short durations of these securities also limit sensitivity to interest rate risk.
3. Diversification: Similar to other mutual funds, money market funds provide instant diversification across a range of securities. This diversification is a crucial safeguard for portfolio stability.
4. Stability and Security: Money market funds are among the least volatile investment types, providing stability and security. This characteristic is valuable in offsetting the greater volatility of other investments, like stocks and bonds.
5. High Liquidity: Money market funds are highly liquid as they typically invest in securities with high demand, such as T-bills and short-term T-bonds. This liquidity allows investors to buy and sell them with ease.
6. Potential Tax Efficiency: Investors in money market funds may enjoy tax efficiency, with interest payments from some fund investments potentially being exempt from federal and state income taxes.
7. Inflation Risk: One significant disadvantage is the risk of losing purchasing power to inflation if the money market fund's return is lower than the inflation rate.
8. Expenses: Annual fees can significantly impact returns, especially when the fund's yield is modest. Investors should be cautious of fees that could eat into profits, making it challenging to keep pace with inflation.
9. Lack of Federal Insurance Protection: Unlike money market accounts at banks, money market funds lack FDIC insurance. In the event of a fund failure, investors may lose some or all of their money, as witnessed during the 2008 financial crisis.
10. Risk of Higher Yields: While generally considered safe, money market fund managers might take higher risks to achieve greater yields. Investors should be aware of the potential for increased risk associated with higher yields.
11. Low Returns and Lost Opportunity: Money market funds often yield lower returns compared to other investments, potentially causing investors to miss out on better opportunities for wealth accumulation over time.
12. Money Market Fund Holdings: Money market funds typically invest in highly liquid and low-risk short-term securities, including short-term Treasuries, government securities, CDs, and commercial paper.
13. Money Market Account vs. Money Market Fund: A money market account is different from a money market fund. The former is an interest-bearing account offered by financial institutions, while the latter is an investment sponsored by a mutual fund company.
14. U.S. Government Insurance for Money Market Funds: Money market funds, like other mutual funds, do not receive insurance from the U.S. government. They are investments with no guarantee of return or principal protection.
In conclusion, while money market funds offer stability and security, investors should carefully weigh the pros and cons, considering factors such as low returns, inflation risk, and lack of federal insurance protection. These considerations are crucial for making informed investment decisions aligned with individual financial goals and risk tolerance.
