Money Market Funds Definition

William_Potter/iStock/GettyImages

Good financial planning means putting money aside for emergencies, college tuition, down payment for a house and retirement. Funds are allocated based on your risk profile. This requires finding a balance between cash on hand, stocks, bonds, real estate and other types of assets that make you comfortable and able to sleep at night.

Money market funds and money market accounts are important parts of that asset allocation. But what is a money market fund, and what is a money market account?

What Is a Money Market Fund and How Does it Work?

A money market fund is a mutual fund that invests in short-term, high-quality securities and pays dividends that are close to short-term interest rates. These funds are liquid, redeemable on demand and rarely fluctuate in price.

They are registered with the Securities and Exchange Commission under the Investment Company Act of 1940 and regulated by SEC Rule 2a-7. The SEC has a responsibility to require registered funds to disclose all relevant risks. The SEC does not insure investors against losses.

Shares of a money market fund are priced daily at net asset value, also known as NAV. The NAV is a fund's assets minus its liabilities on a per-share basis. Retail and government money market funds try to maintain a stable NAV at $1.00 per share. They use special valuation and pricing methods to value their funds' assets and keep that share price.

The NAV of other types of money market funds are not permitted to use these special pricing methods and must allow their NAVs to float. While these funds try to keep up a constant price, their NAVs will change daily based on current market conditions. An investor should be aware of the pricing methods of a fund before buying shares of a money market fund.

Types of Money Market Funds

Money market funds are designed for different kinds of investors. Some funds are structured for retail investors, while others are intended for institutional investors and have high minimum initial investment requirements.

Money market funds are available in four types:

Treasury funds: These funds invest solely in short-term U.S. Treasury securities. They have the lowest risks of all money market funds and pay the lowest interest rates. Treasury funds are designed for investors who want the least risk but want to earn more than the interest on a bank savings account.

Government agency funds: Agency funds invest in the notes and bonds of federal government agencies and are guaranteed by the U.S. Treasury. An example would be the notes from the Federal National Mortgage Association. Although a little riskier than U.S. Treasuries, these funds offer slightly higher yields.

Diversified taxable funds: Diversified funds invest in the securities and bonds of U.S. corporations, commercial paper, repurchase agreements, bankers' acceptances and deposits of foreign banks. All the securities have maturities less than 120 days. These funds are riskier than other money market funds but pay higher yields.

Tax-exempt funds: Tax-exempt funds invest in short-term securities of state and local governments. The composition of these funds varies considerably. Some tax-exempt funds invest only in a single state while other funds have a mix of states. They are the riskiest of all money market funds. Tax-exempt funds are most attractive to investors who are in high-tax brackets and live in states with high income taxes such as New York, Connecticut, New Jersey and California.

An investor who owns several different mutual funds issued by the same company may use a money market fund with the same company to park funds on a temporary basis. Let's say, for example, an investor wants to sell his investment in a stock fund but hasn't decided where to invest next. A money market fund is a good place to put the money until he makes a decision.

Mutual fund companies use their money market funds as a method of providing their clients with overall cash management services. They offer MMFs suitable for small investors. Minimum initial purchases usually range from $500 up to $5,000.

Money market funds offer several ways to withdraw funds. Generally, mutual funds allow investors to write checks on the account, but they may require a minimum check amount of $500. Alternatively, an investor can make a request to redeem shares and may mail the proceeds or send the funds by wire transfer to his bank account.

Advantages of a Money Market Fund

Preservation of capital: Investors who are risk-averse and are not comfortable with investments that fluctuate in value put their money in money market funds. These funds only invest in short-term securities with low risks.

Quick access to funds in an emergency: Money market funds are highly liquid. Investors can redeem their shares on a daily basis.

Better yields: Money market funds typically offer higher interest rates compared to yields on bank savings accounts or money market accounts.

Disadvantages of Money Market Funds

Low yields: The interest rates paid by money market funds may not be enough to stay ahead of the inflation rate.

Not insured: Although money market funds invest in high-quality securities, they are, nevertheless, not insured or guaranteed by any federal agency.

Limited withdrawal features: If you need money quickly, money market funds may not be the best choice. You'll have to write a large check or make an electronic bank transfer; both of these methods can take a few days to get the funds where you want them.

Choosing a Money Market Fund

Since money market funds are available in different types, the first decision is to determine which kind is best suited for your risk profile and tax situation. Will it be a short-term Treasury fund, a government agency notes fund, a diversified fund with corporate debt or a fund that invests exclusively in tax-free securities?

How much interest do you want to receive? U.S. Treasury funds have the lowest yields and the least risk while the diversified corporate funds will have the highest rates, but slightly more risk.

What about your tax situation? If you're in a high-income tax bracket and live in a high-tax state, a tax-exempt fund may give you the best after-tax return.

Do some research and identify a mutual fund company that offers a family of funds including a money market. This will give you the ability to move funds from cash to stock or bonds as market conditions change.

Get a prospectus and compare the fees for operating expenses for several money market funds.

Compare the minimum required initial investment. This amount varies among MMFs.

Understand the procedures for withdrawing funds from the MMF. Is there a minimum amount for writing checks? How long does it take to redeem shares? Is it possible to transfer funds electronically?

What Is a Money Market Account?

A money market account is an interest-paying account that usually pays a higher interest rate compared to a savings account. It is insured up to $250,000 by the Federal Insurance Deposit Corporation for bank accounts and the National Credit Union Administration for accounts at credit unions.

Banks may require higher minimum balances for an MMA than regular savings accounts. Money market accounts have restricted facility to write checks.

Financial institutions frequently pay interest on money market accounts on a tiered basis, which means that the rate of interest is based on the amount of funds in the account; higher balances receive higher interest rates.

Advantages of a Money Market Account

The Federal Reserve Banks allow an MMA account holder to write up to six checks per month. If the account has a debit card, the Fed also allows up to six withdrawals per month. Therefore, an MMA has the benefits of both checking and savings accounts.

However, be aware that a money market account is not a checking account. If you need the ability to write more checks or make more frequent debit card withdrawals, an interest-bearing checking account might be a better alternative, even if it pays a lower interest rate.

The following are the advantages of a money market account:

  • The FDIC and/or NCUA insures the accounts.
  • Many financial institutions offer access to the account through a network of ATMs.
  • Some banks permit the use of a money market account as overdraft protection for your checking account. However, overdraft transfers count against the six-transfer monthly limit per Regulation D.
  • A few banks may offer free checks with an MMA.
  • MMA is a safe place to have funds available for emergencies.
  • Sometimes financial institutions have high minimum balances to open a money market account; up to $10,000.
  • Interest rates on MMAs fluctuate depending on changes in overall short-term market rates.
  • Many banks require the account holder to maintain a minimum balance to avoid monthly fees. As an example, some banks require a minimum balance, like $2,500, or they charge a fee in the range of $12 per month to cover account maintenance.

Disadvantages of a Money Market Account

Higher minimum balances: Banks may require money market accounts to maintain a higher minimum balance than a savings or checking account. Balances lower than the minimum could trigger high maintenance fees. Some banks offer a few ways to lower your minimum balance requirements, such as making direct deposits instead of checks.

Limited withdrawals: Regulation D limits the number of transaction withdrawals to six per month. This includes checks, money transfers out of the account, preauthorized deductions, third-party payments and debit card withdrawals. The good news is that some banks do not count a withdrawal from a teller towards the limit.

Excessive withdrawal penalties and fees: Banks may charge punitive fees if an account holder makes drawings in excess of the six allowed withdrawals per month.

Temporary introductory rates: Banks may offer higher introductory fees when opening a money market account, but these attractive rates will disappear over time.

Fees to close an account: While not universally common, some banks may deduct fees to close an account.

Better long-term rates available elsewhere: Money market accounts are safe investments that pay lower rates than other investments such as bonds, stocks and real estate. MMA rates may not be higher than the inflation rate.

What Is the Difference Between a Money Market Account and a Money Market Fund?

Money market accounts are insured by the FDIC or NCUA up to $250,000; money market funds are uninsured.

Money market accounts are opened by depositing funds at a bank or credit union; money market funds are created by purchasing shares from a mutual fund company or investment broker.

Although money market funds are considered safe investments, their returns are lower than bonds and significantly lower than yields on stocks. As a result, investors use money market funds as a place to park their money while waiting for better investment opportunities to appear. Money market funds are also an essential investment vehicle to maintain adequate liquidity in the overall balance of a portfolio.

References

About the Author

James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for work.chron, bizfluent.com, smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.