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What is a money market fund? Here are the basics

At a glance:

  • What is a money market fund?

  • What do money market funds invest in?

  • Safety concerns about money market mutual funds

  • Ways you can use money market mutual funds

  • Summary of money market funds

The money market is the market for short-term debt securities, which are loans that governments and corporations sell to investors. These loans mature between one day and one year, depending on the type. They also pay competitive returns.

Investors may buy and sell individual money market instruments or participate in the money market by investing in money market mutual funds. Though the money market isn't always visible to most of us, it has a strong presence in the economy.

What is a money market fund?

For a small initial investment as low as $500 (depending on the fund), you can participate in money market investments.

How?

Money market instruments usually provide relatively high yields on short-term investments. Direct participation in the money market would require investments of $10,000 or more, which keeps some investors out. Money market funds, however, pool money from large numbers of investors and use it to buy these securities.

An always-low net asset value

The net asset value (the value of a single share, determined daily) of a money market fund is kept at $1.

Although not guaranteed to stay at $1, money market fund net asset values have usually been kept at $1 due to the stability of the underlying investments. This means that if you own 3,380 shares, your fund will be worth $3,380. Fund managers have been able to maintain the $1 per share value by allowing the dividend rate to fluctuate, rather than the share price.

How their returns work

The returns on money market funds depend on the yields of their individual holdings. Due to the short terms of money market instruments, individual yields fluctuate. This causes the overall yield of a money fund to fluctuate as well. Investors who hold money funds can track the funds' yield changes in the financial pages of most major newspapers.

What do money market funds invest in?

Money market mutual funds invest in a variety of money markets.

Examples of money markets

Money market funds invest in US Treasury bills, commercial paper, banker's acceptances, negotiable certificates of deposit, repurchase agreements, and short-term debts of US government agencies. A fund's prospectus or quarterly report will list the instruments it uses. Money market funds exist in a variety of forms, described below.

Some are tax-free

Tax-exempt money funds invest in municipal securities with very short maturities (30–90 days). The interest they earn is usually free from federal tax and some state taxes. Because of the tax-free feature, however, their yields are comparatively lower than those of taxable funds. Over 300 tax-exempt money funds are available on the market.

Government funds

US Treasury funds buy short-term US Treasury bills (T-bills). Their yields are also comparatively lower than those of other funds. This is because their income is free from state and local taxes and because they are considered very safe.

US government funds buy Treasury bills, federal agency notes, and repurchase agreements. Money market mutual funds invest in a large pool of holdings made up of any of the investments listed above, concentrating on non-government securities.

Safety concerns about money market mutual funds

The Federal Deposit Insurance Corporation (FDIC) insures bank deposits up to $250,000 (retirement accounts up to $250,000), and the National Credit Union Share Insurance Fund (NCUSIF) does the same for credit union shares, but they do not cover money market mutual funds. This is a concern to some investors.

There is another option

You can, however, get a money market deposit account from a federally insured bank. This is a savings account that pays money market rates (which are usually higher than those of passbook accounts). Initial deposits for these accounts are often high, starting at $5,000 or $10,000. However, in recent years many institutions have lowered their initial deposit requirements, some to as low as $500.

Money market funds are considered very safe because of their low volatility and the creditworthiness of the issuers. Money funds also tend to have low overhead costs. These savings are ultimately passed on to investors in the form of yields that are higher than what money market deposit accounts, certificates of deposit, and savings accounts pay.

There is the risk of inflation

A second concern with these funds is inflation risk. Real returns are affected or even overcome by inflation. Inflation can chip away at returns of money market funds because of their low returns, which are consistent with the returns of high-quality, short-term instruments.

Ways you can use money market mutual funds

Money market funds come with some privileges that most other mutual funds do not have.

Checks and business

You can write checks from your money market fund without charge. Most funds, however, will require that checks be written for a minimum amount—say, $250 or more.

You can use a money market fund for business purposes. You can deposit checks from customers and pay bills out of your account.

For a parking spot

A fund can be used as a temporary place to park money that is awaiting investment in another security. Some investors place large sums into these accounts and then withdraw them gradually for placement into stocks and bonds. Many investors also keep cash in their money market funds for emergency use.

Some funds allow you to withdraw cash from ATMs for a fee.

Once you have established a money market fund, you can invest in other funds within the same family without filling out an application.

Summary of money market funds

Money market funds are a convenient way to invest in short-term, interest-bearing securities. Because these instruments are short-term, money market funds are considered cash equivalents and often have higher returns than bank savings and checking accounts.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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