A popular type of mutual fund is the money market fund. Money market funds are designed to have low volatility by investing only in cash or cash-equivalent securities. Such investments usually have high credit quality and high liquidity.
Typical money market fund investments include bankers’ acceptances, commercial paper, certificates of deposit, US Treasury securities, and repurchase agreements. According to rules issued by the Securities and Exchange Commission (SEC), securities in a money market fund must have an average maturity of 90 days.
Why invest in a money market fund?
Money market funds stand out from other investments for three primary reasons. First, these funds are relatively safe investments. Experts view them as among the most stable investment choices. The risk of default on debt securities is low since they are issued by banks, corporations, and governments.
At the same time, these securities offer a reasonable, fixed return on investment. Because of this stability, money market funds are often included in retirement portfolios, where steady returns are important.
The other draw of money market funds is their low initial investment. Securities purchased by these funds tend to have very large purchase requirements, making them inaccessible to everyday investors.
Through a fund, however, individuals can invest for substantially less. In fact, money market accounts tend to have lower average minimum requirements than other types of mutual funds. This makes them a great choice for beginning investors who do not have a lot of money to invest.
Additionally, money market funds are not under the same market timing restrictions as other types of investments. This means that shares can be bought and sold whenever the investor wishes. Also, these funds tend to have same-day settlement, unlike the three-day waiting period of most other types of mutual funds.
What are the tax implications of a money market fund?
There are two different types of money market funds. Taxable funds will incur normal state and federal taxes on any returns. These funds tend to invest in US Treasury securities and other government agency securities, although many other options exist.
Investors can also purchase shares in a tax-free money market fund, although these funds have less flexibility when it comes to purchasing securities. The only securities tax-free funds can invest in come from federally tax-exempt entities, such as municipal securities.
As a general rule, tax-free investments have a lower yield. Very few funds offer exemption from both federal and state taxes. This means that it is important to read the fine print before making a purchase.
When deciding between taxable and tax-free options, investors should consider whether the tax savings truly compensate for the lower yield. Some brief calculations can help determine the likely net yield for a taxable investment.
If that yield is still higher than the tax-free option, then the optimal choice is a taxable money market fund. Figuring out the correct tax rate can be difficult, but it is critical to get as close to reality as possible to have the most accurate comparison.
What issues arise with money market funds?
While money market funds are relatively safe investments, investors still need to be cautious about a few important issues. The most critical consideration is the expense ratio.All mutual funds have expense ratios, but most mutual funds have higher rates of return than money market funds. Because returns are relatively low with money market funds, high expense ratios can significantly inhibit their earning potential. In some cases, money market funds can actually have negative yields if the operating costs are greater than returns.
When shopping for money market funds, investors should look for the lowest expense ratios. This information is always included in the prospectus. If the prospectus is dated, a fund website can provide up-to-date information.
A second potential cause for concern is fees. Money market funds do not always make the best candidates for multiple transactions, since investors could be subject to low-balance fees, per-transaction fees, and check-writing fees, among others. Furthermore, some companies charge an annual account service fee in addition to the expense ratio.
Another risk involved with money market funds involves inflation. These funds provide safety and short-term returns. As a result, their returns tend to be much lower than funds investing in stocks, bonds, and other investments that carry greater risk.
For that reason, there is no guarantee that the rate of return will actually keep pace with inflation. In fact, typical rates of return for money market funds are only slightly above inflation. Thus, money market funds are not ideal for people who have other long-term investment goals.
Investors should also understand that money market funds are not free of risk entirely, although there is only one time in history that a fund failed to repay at least the investors’ principal. In 1994, the Community Bankers Money Market Fund of Denver ultimately paid 96 cents on the dollar when it was liquidated. This means that investors could still lose money with this type of investment, even if the possibility is remote.