Money market funds offer higher yields than savings accounts but are relatively safer than bonds. Therefore, if you're looking for a place to keep your money that is both safe and has higher interest rates than a basic savings account, money market funds can be a smart way to build your short-term savings or emergency fund.
There are many types of money market funds for many types of investors. Some funds invest in U.S. Treasuries, while others might invest in riskier assets for the sake of earning higher interest rates. Chances are there is an option to suit your risk level and savings needs.
What Is a Money Market Fund?
A money market fund is a mutual fund that invests in short-term, high-quality fixed-income securities. The goal of a money market fund is to have a net asset value that does not deviate from $1 per share. In other words, if you invest $1,000 in a money market fund, the goal is to return $1,000 plus a nominal yield (which tends to stick close to 90-day Treasury rates). Losses in money markets have been rare, but they have occurred.
Money market funds are regulated by the US Securities and Exchange Commission (SEC). The SEC seeks to assure that risks are limited and to protect investors’ interests. Also, many firms that sell money market funds purchase extra protection through The Securities Investor Protection Corporation (SIPC). The SIPC further insures against a client's loss of money in funds that are bought from the firm. For this reason (and many others) money market funds can be a smarter way to save money than hiding it under your mattress, especially since the latter carries the risk of theft or fire.
Money market funds are securities, not cash. So, the safeguards offered by the SIPC are not the same as what the FDIC would cover for a bank account. The SIPC does not protect against value declines, credit risks, or fees.
SEC Rule 2a-7 Governs Many Features of Money Market Funds
As a result of the last financial crisis of 2008, the SEC created new rules to assure investors who have money market funds that they will be stable. The rules touch on many aspects of money market funds, and set standards with intent to maintain a stable net asset value per share. Some of the highlights include:
Maturity of Holdings
Money market funds cannot hold investments that mature at a date of greater than 397 days from purchase. The dollar-weighted average maturity of the fund cannot exceed 90 days.
No less than 2.5% of a money market fund’s holdings may be in investments that are in the second highest short-term rating categories.
Money market funds must maintain a diversified portfolio. A money market fund cannot have any single holding that exceeds 5% of the value of the fund (with the exception of US Treasury and government agency holdings).
Advantages of Money Market Funds
The regulation of money market funds is the key behind their many perks:
The main goal of money market funds is to preserve capital. While a few money market funds have broken the buck (gone below $1) in most cases, the fund company or sponsor has stepped in to absorb the losses.
Money market funds provide easy access to cash. Some brokerage accounts offer a money market fund as a sweep option. In other words, when an investment is bought or sold, money comes out of or goes into, the money market fund.
Money market funds pay a yield based on the holdings of the underlying fund. In most cases, the yield is automatically reinvested into the fund via the purchase of additional shares in the fund. This yield makes money market funds a more attractive choice than a savings account with no APY.
Read the prospectus before investing in money market funds, along with other shareholder reports and data that you can access from public sources.
The Bottom Line
Money market funds can be a smart saving and investing tool if you want to earn higher interest rates than bank accounts but also want something safer than bonds. As with all types of securities and savings tools, money market funds may not be right for all investors, so be sure to research the details, and talk to a professional if needed.