What are they?
Money market mutual funds (usually referred to as money market funds or money funds) invest in short-term, fixed-income securities, otherwise known as money market investments. By definition, money market investments mature in less than one year.
Like other mutual funds, money market funds are pooled investments that allow investors to participate in a diversified portfolio managed by professionals to meet certain goals, which are stated in the fund's prospectus.
There are two basic types of money market funds, taxable and tax-free. Taxable money market funds can be further broken down into different categories, including:
- General-purpose funds that are available to all investors directly from sponsoring mutual fund companies
- Stockbroker-affiliated general-purpose funds, also available to all investors, but which are often provided as part of a broader spectrum of broker services
- Special-purpose funds that are organized for individuals who have a particular affiliation, such as customers of a certain bank or special interest group
Money market funds versus money market deposit accounts
The main difference between money market funds and money market deposit accounts is that money market funds are not insured or guaranteed by the FDIC or any other government agency. Although money market funds seek to preserve the value of your investment at a constant value of $1 per share, it is possible to lose money in a money market fund. However, some money market funds may have arranged for private insurance. Because insurance always comes at a cost, insured accounts generally offer lower yields than uninsured funds.
Taxable money market funds
The yield on money market funds generally falls somewhere between those of FDIC-insured money market deposit accounts or short-term certificates of deposit (CDs), and those offered by longer-term CDs, which generally offer higher returns in exchange for tying up your money for periods in excess of one year.
Some money market funds invest exclusively in government money market investments, such as Treasury bills (T-bills) and other obligations of the U.S. government or its agencies. Because these conservative funds hold only instruments backed by the full faith and credit of the United States, their yields are likely to be lower than other funds that may invest in securities regarded as higher risk, such as commercial paper (issued by corporations) and Eurodollar certificates of deposit (which involve risks associated with foreign investing, such as currency fluctuations).
Yields on money market funds vary over time, and some funds may pay a higher rate than others either because they are designed to take higher risks or because they charge lower fees. You should review these policies and fee structures as they are described in each fund's prospectus to determine a fund's true yield over time.
Tax planning for mutual funds requires you to know that earnings from money market funds occur in three ways: interest and dividend distributions, capital gain distributions, and profits from selling fund shares.
Tax-free money market funds
Tax-free money market funds invest primarily in short-term obligations of tax-exempt entities, such as state and municipal authorities. The interest on these instruments is not subject to federal income tax, but may be subject to state and/or local income taxes. For certain investors, a portion of that interest may be subject to the alternative minimum tax.
Generally, income generated from U.S. Treasuries is exempt from state income tax. (Note that the tax-exempt benefit generated by U.S. government agency obligations, such as Ginnie Maes, usually does not pass through to shareholders).
There are also state-specific tax-free money market funds that concentrate in short-term securities issued within a particular state, providing residents of that state with income that is exempt from state and local taxes as well as federal tax.
Some tax-free funds diversify their investments throughout the United States and U.S. territories, such as Puerto Rico and Guam. Since some states have higher credit ratings than others, interest rates vary on these funds. A geographically diversified portfolio of municipal securities spreads out risks among states with varying credit strength.
Taxable versus tax-free money market funds
Depending on your tax bracket, you may find that your returns are actually better with tax-free investments, even though they pay a lower rate, because on an after-tax basis you get to keep more of the money you earn. To determine which makes more sense for you, you need to compare the tax-equivalent yields of both funds. To do this, compare the yield of a tax-free fund to the after-tax yield of a taxable fund. To determine after-tax yield, multiply the rate of return by 100 percent minus your tax rate. In other words:
Pretax return X (100% - tax rate) = after-tax rate of return
For example: Assume you are in the 25% tax bracket and you earn a pretax return of 10%.
10% x (1 -.25) =.075 or 7.5% after-tax rate of return
Liquidity and flexibility
It's easy to invest in a money market account. You can open an account and make deposits and withdrawals virtually any time you want. Your money is not tied up for any specific time period.
Check-writing and other privileges
Money market funds typically offer such services as check-writing privileges and/or the ability to transfer funds by telephone or the Internet from your money market fund to another mutual fund in the same family or to your checking account. There are usually restrictions on minimum check amounts and service fees may apply. These conditions are described in each fund's prospectus.
Many fund families allow you to establish a periodic investment plan, drawing as little as $25 a month from your regular checking account to invest in your money market fund. This can be a relatively painless way to accumulate assets.
Higher interest rates
Money market funds usually offer higher rates than traditional savings accounts.
A convenience for active investors
Because money market funds are offered by both brokerage houses and mutual fund companies, they can be convenient places to hold your cash while you look for other investment opportunities. Most large brokerage houses provide their own money market funds and, with your authorization, they will automatically invest any money that you receive from buying and selling other investments in a money market fund. Likewise, when you want to make an investment, the broker will take the funds needed for the purchase out of your money market fund account.
Money market funds are not required to maintain a $1 per share price
Money market funds are not bank accounts, and as noted above, they are not FDIC-insured. However, fund companies will go to great lengths to avoid "breaking the buck." On some occasions, if a money market fund's income fell below the level required to maintain a $1 per-share value, the investment companies that sponsored the funds voluntarily made up the difference to fund shareholders. However, the sponsoring companies are not obligated to do so, and there is no guarantee that they will always do so.
Restrictions may apply
Although it is usually easy to make deposits and withdrawals from money market funds, the fund sponsor may impose certain restrictions on the account. For example, initial requirements to establish a money market fund can range from $25 to establish a monthly investment plan to initial deposits of $25,000 or more. Subsequent deposits may also have minimums.
In addition, the companies offering money market funds may give shareholders check-writing, Internet or electronic transfer, or ATM privileges. However, the companies may impose restrictions on such withdrawals or charge fees for these services. Restrictions and fees are described in each fund's prospectus.
Shareholders pay the fund's expenses
Mutual funds operate by pooling investors' money and paying a professional money manager to invest it. The manager charges the fund a fee. In addition, the fund will charge fees for servicing shareholder accounts; some may also charge marketing fees.
Mutual fund fees are usually calculated as a percentage of the fund's assets. All fees are deducted before any distributions are made to shareholders.
How to invest
Money market funds are available from mutual fund companies directly as well as from banks and brokers. Application forms to establish an account are usually included in the fund's prospectus.
The terms and conditions of each money market fund vary considerably. For this reason, it is important to shop around for a fund that meets your needs for current income and convenience. Be aware that the returns listed in the prospectus are past returns and do not guarantee future returns. Before investing in any mutual fund, carefully consider its investment objectives, risks, charges, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing.