A money market fund is a type of investment vehicle. In comparison to a typical mutual fund, money market accounts have low risks. In the world of investing, the lower the risk means the safer the investment vehicle is and the less the annual return is.
Despite the low returns, a money market fund is a great option for many investors. We’ll cover everything you need to know about this type of fund below.
How Does a Money Market Fund Work?
A money market fund invests in cash and cash equivalent securities or instruments. These investing options are focused on short-term investments that are backed with a high credit quality. Said differently, this type of fund will not invest in risky stocks, bonds or commodities.
Money market funds typically invest in: certificates of deposit, repurchase agreements, treasuries, commercial paper, bankers acceptance, and various debt instruments that pay dividends.
What Is the Point of a Money Market Fund?
Money markets play an important role in the investment world. Their primary purpose is to provide an investor with a very safe, liquid investment that earns an interest rate greater than a traditional savings account. A corporation uses a money market fund to finance various short term obligations in the organization.
Investors often use a money market account if they have concerns on the overall stock market, or if they are looking for a place to park cash before making another investment. They also use a money market fund to park cash, but have that cash earn a greater interest rate than a traditional savings account.
Is It a Good Investment?
Unfortunately, there is not a clear answer here. Before you can determine if something is a good investment or not, you must understand your goals and desired outcomes.
If you’re looking for capital appreciation, or earning a great interest rate, a money market fund is not a great investment. The interest rates on money market funds lag the performance of the stock market, so one would say you’re leaving money on the table.
If you’re looking for a safe, liquid investment, a money market fund may be a good option for you. You can easily pull out your cash, and the fund will invest in extremely safe investment options. The interest rate you’ll receive will be greater than the interest rate on a traditional savings account
How to Buy a Money Market Fund
One can invest in a money market fund a few different ways. Money market funds can be purchased through Fidelity or Vanguard. You’ll also be able to purchase money market funds through a brokerage account.
Money Market Instruments
There are various instruments a money market fund will invest in. These include the following.
Commercial Paper
Commercial paper is a short-term, unsecured debt issued by US corporations. Corporations issue commercial paper to cover various financing needs, such as payroll, bills, or other short term liabilities.
Bankers Acceptance
A bankers acceptance, also known as a BA, is a piece of paper that acts like a post-dated check. The bank guarantees the payment of the given piece of paper. Companies use bankers’ acceptance on large transactions. Most commonly, a banker’s acceptance is used in international trade. A buyer will provide the supplier with a bankers acceptance as a form of payment. This reduces the suppliers risk of supplying the buyer with the goods as the bank has guaranteed the payment.
Repurchase Agreement
A repurchase agreement, also known as a “repo,” is a type of short-term borrowing when dealing with government securities. A dealer will sell a buyer these securities for cash, and promises to buy those securities back at a later date (typically within a week) for a higher cost. The delta between the original price and the repurchase price is the interest the buyer earns for buying the securities.
Types of Money Market Funds
There is not a one size fits all money market fund. Various money market funds invest in specific types of securities. Consulting with a financial advisor is the best way to fully understand the pros or cons of each type of fund.
Prime Money Fund
A prime money fund will invest in variable rate debt and commercial paper assets. These assets can be issued by various corporations, or US government agencies.
Government Money Fund
A government money fund invests at least 99.5% of their total assets in highly liquid government securities.
Treasury Fund
A treasury fund is a mutual fund that aggregates money from numerous investors and buys low-risk government securities. These funds invest debt issued by the US government, either treasury bills or repurchase agreements.
Tax-Exempt Money Fund
A tax-exempt fund invests in short-term debt that’s issued by tax-exempt entities. Although it’s uncommon, an investor can find a tax-exempt fund that is exempt from both federal and local state taxes. There are not many options for tax-exempt funds and the interest rates are typically rather low.
Advantages and Disadvantages of Money Market Funds
Before you can decide if a money market fund is good for you, let’s examine the pros and cons.
Benefits of Money Market Funds
First and foremost, money market funds are liquid. Investors can quickly and easily withdraw money from their money fund, typically within 24-72 hours. If you ever needed the cash, or had any concerns, you won’t have a problem accessing your money.
Secondly, money market funds are low risk. They invest in high quality investment options that are not nearly as volatile as even the best of breed blue chip stocks.
Last but not least, a money market fund offers a higher yield, or interest rate. Instead of keeping your investments in cash or a cash equivalent, like a checking or savings account, having your money in a money market fund will earn slightly more interest without losing flexibility.
Disadvantages of Money Market Funds
There is no such thing as a risk free investment, so let’s examine some of the disadvantages a money market fund has.
A money market fund is not insured by the FDIC. It is very unlikely, but an investor could lose the money they deposit in this fund in the event the fund went bankrupt.
This fund still does not earn a lucrative interest rate. These funds are designed for capital preservation, not capital appreciation. If you’re looking to earn an interest rate to grow your portfolio value, or live off the profit you earn in interest, a money market fund may not be your best bet.
Lastly, there isn’t an opportunity cost risk or inflation risk that must be considered. If a money market fund is paying you a 1% interest rate, and a CD can pay you 2.5% interest rate, that delta is the opportunity cost you lost for investing in this type of fund.
Additionally, if inflation grows at a greater rate than the interest rate you received on the money market fund, you technically lost purchasing power on your dollar.
It’s Okay to Ask for Help
If you’re not sure where to invest your income, consider investing in a money market fund. You’ll earn a greater interest rate when compared to a typical savings account, and these funds still provide you with a great deal of liquidity on your money. These funds are great short term options, but if you’re looking to earn a healthy interest rate, or grow your capital, this type of fund may not be your best long term option.
One of the hardest things one could do with their money is invest it properly. There are countless variables one must consider, such as; opportunity cost, liquidity, risk, inflation and interest rates. If you’re uncertain about where you should invest your cash, or how you can maximize your return, getting feedback and insight from a financial advisor can certainly get you on the right path.
Financial advisors exist to make sense of the financial world. They’ll take a holistic view of your finances and will help you reach your financial goals!