Money market funds are a popular cash management tool. Before you use money market funds, make sure you know what they are, how they work, and what risks you might be taking.
What are Money Market Funds
Money market funds are mutual funds that invest in the “money markets”. If you imagine that people buy and sell stocks in the stock market, then you can see how people buy and sell money in the money markets. What does it mean to buy or sell money? It means that you borrow or loan money, respectively.
Similar to your deposit accounts at the bank, money market funds take your money and invest it. Then, they pay a portion of their earnings to you in the form of dividends. Money market funds usually pay a monthly dividend, but there are some alternatives out there.
What do Money Market Funds Invest In?
These funds invest in short term instruments that mature in less than 13 months – at a maximum. By keeping a short time-frame, these funds attempt to reduce risk. In fact, the SEC says that the average maturity of all the investments in a money market fund must be less than 90 days. The longer you loan money to somebody, the greater the chance that something will happen and they won’t be able to pay you back.
Typical investments inside a money market fund might be US Treasury issues, short-term corporate paper, and CD’s.
What Risks am I Taking in Money Market Funds?
There are at least three risks that we should highlight.
First, a money market fund is technically a security. The fund managers attempt to keep the share price constant at $1/share. However, there is no guarantee that the share price will stay at $1/share. If the share price goes down, you can lose some or all of your principal. The US Securities and Exchange Commission notes that “While investor losses in money market funds have been rare, they are possible”. In return for this risk, you should earn a greater return on your cash than you’d expect from an FDIC insured savings account (money market funds are not FDIC insured).
Next, money market fund rates are variable. In other words, you don’t know how much you’ll earn on your investment next month. The rate could go up or down. If it goes up, that may be a good thing. However, if it goes down and you earn less than you expected, you can end up needing more cash.
A final risk you’re taking with money market funds has to do with inflation. Because money market funds are considered to be safer than other investments like stocks, long term average returns on money market funds tends to be less than long term average returns on riskier investments. Over long periods of time, inflation can eat away at your returns.
Why Would I Use Money Market Funds?
Investors who want a decent return from a relatively safe investment use money market funds. The investments are typically liquid, meaning you can usually get your money out within a few business days. You can also take advantage of rising interest rates by keeping your money in an investment that will adjust to the markets.
A lot of institutions allow you to write checks that draw from a money market fund. Therefore, you get the advantages of dividend earnings as well as easy access to your cash. Make sure you ask what restrictions or fees your institution has.
Where Can I Get a Money Market Fund?
When it comes to money market funds, you have choices. They are easy to find at brokerage houses and mutual fund companies – your free cash is sometimes swept into a money market fund automatically. More recently, banks are offering money market funds to their customers.
Where Can I Learn More About Money Market Funds?
The best place to find out about a money market fund is the fund's prospectus. You should always read one of these before buying any fund, and you can really learn a lot by reading the prospectus from several different funds.
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