Money Market Funds: Where To Invest For Smart Returns

Money market funds are a type of mutual fund that invests in short-term, low-risk debt securities such as U.S. Treasury bills, municipal bonds, and commercial paper. These funds are known for their short maturity and high liquidity, which makes them a relatively safe place to hold money, like an emergency fund or cash reserves, temporarily. Money market funds are also an acceptable alternative to traditional savings accounts because they have historically provided higher returns.

When considering where to invest in money market funds, it is important to evaluate the type of fund, minimum investment requirements, the expense ratio, and average yield. Money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC); however, brokers and dealers should be members of the Securities Investor Protection Corporation (SIPC).

Money market funds vs money market accounts

Money market funds and money market accounts (MMAs) are distinct financial products with different features and levels of risk. Here is a detailed comparison of the two:

Money Market Funds

Money market funds are a type of mutual fund that invests in highly liquid, short-term, low-risk debt instruments. These include cash, cash-equivalent securities, and high-credit-rating debt securities with short-term maturity, such as US Treasuries. Money market funds aim to provide investors with high liquidity and very low risk. They are ideal for investors who want to temporarily park their money before investing elsewhere or making anticipated cash outlays. Money market funds are not suitable for long-term investments as they offer little capital appreciation.

Money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC) but are covered by the Securities Investor Protection Corporation (SIPC). They are offered by financial institutions such as banks, brokerage firms, and mutual fund companies. While money market funds carry a very low risk, there have been rare instances where funds "broke the buck", i.e., their net asset value (NAV) dropped below $1. In such cases, the fund may be liquidated, and investors could receive less than $1 per share.

Money Market Accounts

Money market accounts, on the other hand, are a type of interest-earning bank account or deposit account. They are similar to savings accounts but generally offer higher interest rates. Banks can offer these higher rates because they invest the funds in high-quality, short-term securities. MMAs are insured by the FDIC for banks or the National Credit Union Administration (NCUA) for credit unions, up to $250,000 per depositor.

MMAs usually come with ATM cards, debit cards, paper checks, or other easy ways to access funds. However, they often have limitations on the number of withdrawals per month, typically restricted to six. They also tend to have higher minimum balance requirements than other deposit accounts.

Key Differences

The main differences between money market funds and MMAs are in terms of risk, liquidity, and returns. Money market funds offer lower risk and higher liquidity but may provide lower returns compared to MMAs. MMAs are considered safer due to the federal insurance, but the returns are dependent on interest rates and can vary across banks. Money market funds have the advantage of being more liquid, with no limits on withdrawals, but they are not insured against loss.

Types of money market funds

Money market funds are typically divided into three categories: government, prime, and municipal. Here's what you should know about each type:

Government Funds

Government money funds invest primarily in cash, U.S. Treasury securities, and repurchase agreements that are collateralized by cash or government securities. They are considered extremely safe since they invest in low-risk assets and aim to maintain a stable $1 net asset value (NAV). Treasury Funds, which invest in standard U.S. Treasury-issued debt securities such as Treasury bills, bonds, and notes, are also included in this category.

Prime Funds

Prime money funds, also known as general-purpose funds, invest in a diverse range of assets, including government securities, commercial paper, certificates of deposit, short-term securities issued by domestic and foreign corporations, and repurchase agreements. Prime funds are suitable for investors seeking a balance between safety and higher returns.

Municipal Funds

Municipal money market funds, also known as tax-exempt funds, invest primarily in securities that are exempt from federal income tax, such as municipal bonds and other debt securities. These funds are attractive to investors in high tax brackets as they provide tax-advantaged gains.

It's important to note that money market funds are different from money market accounts (MMAs). Money market funds are mutual funds sponsored by investment companies, while money market accounts are interest-earning savings accounts offered by financial institutions and insured by the FDIC.

How to choose a money market fund

Money market funds are a type of mutual fund that invests in short-term, highly liquid, low-risk debt. They are considered a safe investment option, comparable to high-yield savings accounts.

• Yield: Compare the fund's yield with other funds in the industry to ensure you're getting a good return on your investment.
• Expense ratio: Funds charge an expense ratio, which is taken from the returns you earn as an investor. A lower expense ratio is generally better as it means more of your returns stay with you.
• Type of fund: Money market funds are typically divided into three categories: government, prime, and municipal. Government funds invest in U.S. Treasury securities and are considered the safest option. Prime funds invest in a mix of government securities and corporate securities, offering higher returns but with slightly more risk. Municipal funds invest in tax-exempt securities, making them appealing to those in high tax brackets.
• Other fees: Be mindful of any additional fees, such as mutual fund commissions or fees for specific fund families, that may be charged when buying and selling money market funds.
• Credit ratings: Assess the credit risk of the fund by looking at the credit ratings of the individual securities held by the money market fund. The safest funds are often invested in U.S. government treasury securities.
• Tax implications: Taxable funds invest in securities that are federally taxable, while tax-exempt funds invest in state and local government-issued securities that are not subject to federal taxation. If you're in a higher tax bracket, consider tax-exempt funds as they may offer a higher after-tax yield.

Remember, money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC), so there is a small risk of losing money. Ensure you understand the fees and risks associated with any investment before proceeding.

Are money market funds taxable?

Money market funds are divided into two categories: taxable and tax-free. If you invest in a taxable fund, generally, any returns are subject to regular state and federal taxes. Taxable funds primarily invest in U.S. Treasury securities, government agency securities, repurchase agreements, CDs, commercial paper, and bankers' acceptances.

On the other hand, tax-free funds do not offer as many options and have a lower yield. These funds invest in short-term debt obligations issued by federally tax-exempt entities (municipal securities). In some cases, you can purchase tax-free funds that are exempt from both state and local taxes, but these are exceptions rather than the norm.

It's important to note that the tax status of a money market fund does not determine whether or not your investment returns are taxable. Instead, it indicates whether the fund itself will pay taxes on its investment income or pass those taxes on to investors.

When deciding between tax and tax-free funds, it is crucial to calculate whether the tax savings offered by the tax-free fund will be sufficient to make up for its lower yield. Taxable funds generally offer higher returns, but if the tax on those returns cancels out the additional return, the tax-free fund becomes the more optimal choice.

Alternatives to money market funds

Money market funds are a type of mutual fund that invests in short-term, highly liquid, low-risk debt. They are a safe investment option, but their yields can be low.

Ultra-Short Bond ETFs

These involve only a modest step up in risk from money market funds, but can offer higher yields. For example, yields on ultra-short bond ETFs can be as high as 1% today. While these funds don't maintain a stable $1 share price like money market funds, the risk is usually small, and they can be a good option if you're willing to hold for a little longer. Examples include:

• PIMCO Enhanced Short Maturity Active ETF (MINT)
• BlackRock Short Maturity Bond ETF (NEAR)
• Vanguard Ultra-Short Bond ETF (VUSB)
• JPMorgan Ultra-Short Income ETF (JPST)
• PGIM Ultra Short Bond ETF (PULS)
• BlackRock Ultra Short-Term Bond ETF (ICSH)

Bank Money Market Accounts

These are offered by banks or credit unions and typically earn a higher rate of interest than a standard savings account. They are insured by the Federal Deposit Insurance Corporation (FDIC) and provide more liquidity, ATM access, and overdraft protection than money market funds.

Ultrashort Bond Funds

These compete with money market funds and may include investing in a wider variety of assets, aiming for higher returns.

Enhanced Cash Funds

These are another alternative to money market funds, which may provide higher returns.

Frequently asked questions