Money Market Funds: How Do They Work?

Money market funds are a valuable addition to any investment portfolio due to their stability and liquidity. Keeping money in this type of fund is almost as safe as keeping it in a savings account, but there are many added benefits that make the money market fund more appealing. If you’re interested in a low-risk investment, read on to learn more about how money market funds work, the different types of funds available, and how to best use this type of investment yourself.

What Is a Money Market Fund?

money market funds

Image via Unsplash by micheile

A money market fund is a type of mutual fund. When it was first developed in the 1970s, this type of investment was designed to offer better returns than low-yield savings accounts. Money market funds are primarily invested in highly rated low-risk debt instruments.

A money manager will distribute your investment appropriately so you don’t have to worry about selecting the individual investments. These money managers aim to keep the net asset value (NAV) at $1 per share, never losing money.

A money market fund usually invests your money in:

  • Commercial paper.
  • U.S. Treasuries.
  • Certificates of deposit.
  • Bankers’ Acceptances.
  • Repurchase agreements.

Types of Money Market Funds

Each money market fund is invested a little differently, so you may want to consider the type of fund you choose if you have a preference for a particular type of investment. There are four primary categories that money market funds fall into:

  • Prime money market funds: These funds invest heavily in non-Treasury assets such as corporate and bank debt securities with the goal of maximizing your returns.
  • Government money market funds: At least 99.5% of a government money market fund is invested in government securities, repurchase agreements, and cash. Backed by the government, these are considered one of the safest securities.
  • Tax-exempt money market funds: These funds are invested primarily in entities whose interest payments are exempt from federal taxes. These funds are comprised primarily of municipal bonds and debt securities. Earnings from this type of money market fund are exempt from the federal income tax, though state taxes may still apply.
  • Treasury money market funds: Investments in Treasury bills, Treasury notes, and Treasury bonds make up the majority of this fund.

Expected Returns on Money Market Funds

By nature, money market funds are short-term investments. A money market fund must:

  • Have a maturity period of 397 days or less.
  • Maintain a weighted average maturity (WAM) period that’s no more than 60 days.
  • Have a weighted average life (WAL) of no more than 120 days.

The WAM for a money market fund is determined by taking the average of the effective maturities of all securities in the portfolio, weighted by the percentage of net assets for each security. The WAL is the average of the final maturities of all securities in the portfolio, weighted by the percentage of net assets for each security.

This low-risk investment also offers a relatively low yield. However, you will rarely lose money in a money market fund. The fund is designed to return your initial investment to you along with interest upon maturity.

The Benefits of Money Market Funds

Money market funds are an appealing option for nearly any kind of investment portfolio. Some of the benefits of this type of fund include:

  • Risk: Money market funds are low-risk investments with high credit quality. This type of mutual fund invests in cash and cash equivalent securities that are relatively stable.
  • Liquidity: Money market funds have great liquidity when compared to other types of investments. You can typically withdraw funds in just a few business days, and some institutions will even allow you to write checks from your money market fund.
  • Diversity: A money market fund is a great choice for a high-risk investment portfolio that needs more diversification. Moving some of your funds from a risky investment to a money market fund will help protect this portion of your investment so you’re nearly guaranteed some earnings.
  • Accessibility: Money market funds generally have a low minimum investment, ranging from $500 to $5,000. This makes them an accessible option for nearly any investor. It’s worth noting, however, that there are also money market funds with high minimums, often set at $1 million.

Money Market Funds vs. Money Market Accounts

Though money market funds and money market accounts sound similar, there are some key differences between these two options. A money market account is essentially a savings account with a higher interest rate. While the interest on a money market account is better than a savings account, it’s usually lower than the interest rate on a CD or the total return on a money market fund.

The primary benefit of a money market account over a money market fund is that the money market account is insured by the financial institution where it is maintained. Money market funds, on the other hand, are not insured by the Federal Deposit Insurance Corporation (FDIC). Though the risk is small with a money market fund, there is still the possibility that you could lose money.

How to Use Money Market Funds

There are many ways that you can use money market funds to your advantage in an investment portfolio. If you’re simply looking for a low-risk place to keep your savings while boosting your interest a bit, a money market fund will do the job.

You can also use a money market fund as a convenient place to store funds while you’re waiting to transfer them between other riskier accounts. If you want to sell a fund but haven’t decided on your next purchase, consider moving the money into a money market fund that’s managed by the same fund company so you can keep your investment growing while you consider your next move.

If you need help managing your investment portfolio, 3D Partners Wealth Advisors can offer expert advice on the best way to move forward. Handling your wealth is a complex matter with numerous considerations including taxes, risk management, and long-term financial planning. We’ll help you create a comprehensive approach for your wealth management.