The Risks and Benefits of Money Market Funds

Looking at share prices through magnifying glass.
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Money market funds are mutual funds that invest in the money markets, meaning debt securities of a short-term nature, such as U.S. Treasury bills. If you imagine that people buy and sell stocks in the stock market, it's easier to see how people buy and sell money in the money markets in the form of shares.

Similar to your deposit accounts at the bank, money market funds take your money and invest it. Then, they pay a portion of their earnings to you in the form of dividends. Money market funds usually pay a monthly dividend, but some alternatives also exist. A money market fund is not the same as a money market account at a bank or credit union.

Money market funds are a popular and useful cash management tool in the right circumstances. Before you use money market funds, make sure you understand how they work and the risks you might be taking.

Money Market Funds Investments

These funds invest in short-term instruments that mature in less than 13 months at a maximum. By keeping a short time frame, these funds attempt to reduce risk. In fact, the SEC reports that the average maturity of all the investments in a money market fund must be less than 90 days.

The longer you loan money, the greater the risk that something could happen and it won’t be paid back. Typical investments inside a money market fund might be US Treasury issues, short-term corporate paper, and CDs that present an extremely low risk of default.

Why Use Money Market Funds

Investors who want a decent return from a relatively safe investment use money market funds. If your portfolio is invested in suddenly-volatile markets, you can pull out your money and park it in a money market fund. Although the returns may be in the low single digits, it's a very low-risk place to keep your money in a down market.

Investments in money market funds are typically liquid, meaning you can usually get your money out within a few business days. You can also take advantage of rising interest rates by keeping your money in an investment that will adjust to the markets.

A lot of institutions allow you to write checks to withdraw your funds from a money market fund. Therefore, you get the advantages of dividend earnings as well as easy access to your cash. Make sure you ask what restrictions or fees your institution has.

The Risks of Money Market Funds

There are several risks that are worth highlighting. First, a money market fund is technically a security. The fund managers attempt to keep the share price constant at $1/share. However, there is no guarantee that the share price will stay at $1/share. If the share price goes down, you can lose some or all of your principal.

The U.S. Securities and Exchange Commission notes that “While investor losses in money market funds have been rare, they are possible.” In return for this risk, you should earn a greater return on your cash than you’d expect from an FDIC insured savings account.

This leads to the next risk, which is that money market funds are not FDIC insured. If you keep money in a regular bank deposit account, such as savings or checking, your bank provides FDIC insurance for up to $250,000. Although money market funds are extremely safe, there is still a small element of risk that you could lose money, without any government entity to cover your losses.

Next, money market fund rates are variable. In other words, you don’t know how much you’ll earn on your investment next month. The rate could go up or down. If it goes up, that may be a good thing. However, if it goes down and you earn less than you expected, you can end up needing more cash. This is the same as other securities investments but is still worth noting if you're looking for dependable and predictable returns on your funds.

A final risk that comes with money market funds has to do with opportunity costs and inflation. Because money market funds are considered to be safer than other investments like stocks, long-term average returns on money market funds tend to be less than long-term average returns on riskier investments. For example, common stock returns average out to 8 percent to 10 percent over time, while money market mutual funds come in at only 2 percent to 3 percent on average. Over long periods of time, inflation can eat away at your returns, and you might be better served with higher-yielding investments.

Where to Get a Money Market Fund

When it comes to money market funds, you have choices. They are easy to find at brokerage houses and mutual fund companies—your free cash is sometimes swept into a money market fund automatically. Check your bank as well, since banks have also been offering money market funds to their customers since they received regulatory permission in 1982.

The best place to find out more details about a money market fund is the fund's prospectus. You should always read one of these before buying any fund, and you can learn a lot by reading the prospectus from several different funds.