What Is a Money Market Fund?

A money market fund is a type of mutual fund that invests in debt securities with fast maturities and minimal credit risk. These funds are among the lowest-volatility investments. Income generated by a money market fund can be tax-exempt, depending on the types of securities in which the fund invests.

The U.S. Securities and Exchange Commission (SEC) defines three categories of money market funds based on the fund’s investments: government, prime, and municipal. SEC rules further classify prime and municipal funds as either retail or institutional, based on the fund's investors.

Who Might Purchase Money Market Funds?

Money market funds might be appropriate for investors who:

• Have an investment goal with a short time horizon.

• Have a low tolerance for volatility.

• Want to diversify with a more conservative investment.

• Need the investment to be extremely liquid.

Although the returns on money market funds are generally lower than those of other fixed-income funds, such as bond funds, they provide stability.

Investors can use money market funds in the following ways:

• To offset the typically greater volatility of bond and equity investments.

• As short-duration investments for assets that may be needed in the near term, such as an emergency fund.

• As a holding place for assets while waiting for other investment opportunities to arise.

Types of Money Market Funds

The types of debt securities held by money market mutual funds are very short-term in maturity and high in credit quality. All funds comply with industry-standard regulatory requirements regarding the quality, maturity, liquidity, and diversification of the investments.

Money market mutual fund investments can include:

• Short-term U.S. Treasury securities

• Federal agency notes

• Eurodollar deposits

• Repurchase agreements

• Certificates of deposit

• Corporate commercial paper

• Obligations of states, cities, or other municipal agencies

The types of money market funds include:

Government

• Treasury only: At least 99.5% of the fund’s total assets are invested in cash and U.S. Treasury securities, including at least 80% in U.S. Treasury securities.

• Treasury: At least 99.5% of the fund’s total assets are invested in cash, U.S. Treasury securities, and/or repurchase agreements collateralized by U.S. Treasury securities, including at least 80% in U.S. Treasury securities and repurchase agreements for those securities.

• Government: At least 99.5% of the fund’s total assets are invested in cash, U.S. government securities, and/or repurchase agreements that are collateralized fully, including at least 80% in U.S. government securities and repurchase agreements for those securities. U.S. government securities include U.S. Treasury securities, and securities of U.S government agencies and instrumentalities. Certain issuers of U.S. government securities are sponsored or chartered by Congress, but their securities are neither issued by nor guaranteed by the U.S. Treasury.

Prime

Assets are invested in any eligible U.S. dollar-denominated money market instruments, including:

• Commercial paper

• Certificates of deposit

• Corporate notes

• Other private instruments from domestic and foreign issuers

• Repurchase agreements

• Reverse repurchase agreements

Municipal

• National municipal: At least 80% of the fund’s assets are invested in municipal securities whose interest is exempt from federal income tax.

• State municipal: At least 80% of the fund’s assets are invested in municipal securities whose interest is exempt from federal and state personal income taxes.

Advantages of Money Market Funds

The advantages of money market funds include:

• Stability: Money market funds are among the least volatile types of mutual fund investments.

• Liquidity: You can easily settle your brokerage account trades in other investments or retrieve funds from a money market fund.

• Security: The funds are required to invest in short-maturity, low-risk investments, making them less prone to market fluctuations than many other types of investments.

• Short duration: Because the duration of money market mutual funds is so short, they are typically subject to less interest rate risk than longer-maturing bond fund investments.

• Diversification: Money market funds typically hold many securities, with limited exposure outside U.S. Treasury funds to any single issuer.

• Potential tax advantages: Some money market funds invest in securities whose interest payments are exempt from federal income taxes, and in some cases state income taxes, providing a source of stable, tax-efficient income.

Risks of Money Market Funds

Money market funds carry the following risks:

• Credit risk: Money market mutual funds are not insured by the Federal Deposit Insurance Corporation (FDIC). Although money market funds invest in high-quality securities and seek to preserve the value of your investment, there is the risk that you could lose money, and there is no guarantee that you will receive $1 per share when you redeem your shares

• Inflation risk: Because of the safety and short-term nature of the underlying investments, money market fund returns tend to be lower than those of more volatile investments, creating the risk that the rate of return may not keep pace with inflation.

Prime Money Market Funds

• Foreign exposure: Entities located in foreign countries can be affected by adverse political, regulatory, market, or economic developments in those countries

• Financial services exposure: Changes in government regulations, interest rates, and economic downturns can negatively impact issuers in the financial services sector, including the price of their securities or their ability to meet their payment obligations.

Prime and municipal money market funds

• Liquidity risk. The fund may impose a fee upon the sale of shares if the fund's board determines that a fee is in the fund's best interests.

Institutional Prime and Institutional Municipal Money Market Funds

• Price risk: Because the fund's share price will fluctuate, when selling shares, they may be worth more or less than what was originally paid.

• Liquidity risk: Institutional prime and institutional municipal/tax-exempt money market funds impose a mandatory liquidity fee if a fund experiences net redemptions that exceed 5% of net assets on a single day, or such smaller amount of net redemptions as the board determines. Retail money market funds and government money market funds are not subject to this requirement.

How to Choose a Money Market Fund

You should determine whether a money market fund’s characteristics align with your investment objectives and strategy when deciding which ones to invest in:

• The objective of many money market funds is typically to provide current income and preserve principal.

• U.S. Treasury and government money market funds can offer a lower credit risk and return profile than prime money market funds.

• Municipal money market funds might be appropriate for nonretirement accounts that are not already tax-shielded.

Retail and Institutional Prime and Municipal Money Market Funds

Retail prime and retail municipal money market mutual funds have policies and procedures designed to limit all beneficial owners to natural persons. These funds may continue to seek to maintain a stable $1.00 net asset value per share (NAV).

Because institutional prime and institutional municipal money market mutual funds do not qualify as retail funds, they can be held by institutional investors. The funds are priced and transact at a floating net asset value (NAV), meaning the NAV is priced to 4 decimal places and will fluctuate.

Non-government money market funds are required to impose a discretionary liquidity fee, not to exceed 2% of the value of the shares redeemed, if the fund’s board or its delegate determines that a fee is in the fund’s best interests. The SEC’s rules require institutional prime and institutional tax-exempt money market funds to impose a mandatory liquidity fee if a fund experiences net redemptions that exceed 5% of net assets on a single day, or such smaller amount of net redemptions as the board determines.

Government money market mutual funds, including U.S. Treasury funds, are available to retail and institutional investors and are not subject to liquidity fees unless they choose to opt in.

*This information is for educational purposes only.

Do you invest in a money market mutual fund, or do you plan to? Let me know in the comments!