Money Market Funds can be safe or risky!

Money market funds are another type of financial asset, designed to give you a predictable rate of return.

As of April 20, 2011, the total amount of money in these funds was $2.71 trillion!
Source - http://www.ici.org/

In fact, you may already invest in one and not even know it. Now THAT is risky!

What are Money Market Funds?

These funds are a type of "cash equivalent", which means that the funds behave the same way as cash-based assets such as savings/checking accounts, paper money, and certificates of deposit.

They are regulated by the SEC, using the Investment Company Act of 1940.

In order to offer a money market fund, an investment firm is required (by law) to invest in securities with very low volatility, and pay you dividends roughly equal to the short-term interest rates set by the Federal Reserve.

So investment firms are more or less forced to manage the money in their money market funds by limiting exposure to credit risk, interest rate risk, market risk, and liquidity risk.

Firms do this by investing in government securities, certificates of deposit, highly rated corporate bonds, or other highly liquid and "low-risk" securities.

Invest Safely Dollar Sign Callout

Safe Investing Tip:
When you practice personal money management as described in this site, you are managing your money by limiting exposure to credit risk, interest rate risk, market risk, and liquidity risk; just like the investment firms.

Why buy Money Market Funds?

The main reason to purchase these funds is that they give you a small return on cash that would otherwise earn you nothing.

So they can be a good choice for a short period of time, but only if interest rates are high enough.

You may be deciding what investments to buy, feel the market is too risky, or just simply need some money in a few months and don't want to worry about it.

A money market fund can provide you with some interest while you wait, with the thought that something is better than nothing.

Similarly, if you get dividends, other income, or proceeds from sales, your broker probably deposits this cash into a low interest rate money market fund automatically. This is called a brokerage sweep account.

The problem with a brokerage sweep account is that it usually pays a fraction of the interest you could get if you just purchased a fund on your own.

Advantages

These funds are required to be "open ended".

  • This means you can buy and sell shares freely

Disadvantages

These funds are NOT federally insured by the FDIC.

Factors affecting Price

Investment firms try to keep the price at $1.00 per share, net asset value (NAV). The firm buys the securities mentioned above, and then varies the yield (your dividend) up and down.

Price can also be affected by the following "outside" influences:

Interest Rates

  • Falling interest rates increase the price of bonds and other investments used by investment firms to control risk. Rising rates reduce the prices.

Maturity

  • Interest rates affect the price of long-term bonds much more than short-term bonds, so the wrong mix can impact your return, just like bond investments.

Credit Ratings

  • If the credit ratings of investments within the fund are downgraded (or default), it will be difficult for a firm to maintain a NAV of $1.00.

All these funds can potentially fall below $1.00 per share, but this only happens when returns from low volatility investments are extremely poor.

While this doesn't happen often, it is possible when rates interest rates are kept extremely low (2008-201x).

Investment Choices

By their very nature, money market funds are financial assets.

Financial Assets

Where to Buy?

You can purchase these funds through any investment broker (i.e. your trading accounts), and even directly from some investment firms.

As with all investments, before putting any of your money into a a money market fund, read the prospectus and recent shareholder reports.

Unfortunately, in the example mentioned earlier (Cash Holdings in a Brokerage Account), you usually do not have a choice. If you hold cash, it will go into a low interest rate fund.

If you do decide to put your idle money elsewhere and try to stick it to the brokerages, remember that you'll pay them commissions on any trades you make.