How They Work

Money market funds are somewhat unique in the mutual fund arena because they are strictly designed to maintain a constant stable price of $1.00 per share at all times. They only pay interest and never produce dividends or capital gains of any kind. There are four main categories of money market funds.

The first category invests solely in short-term Treasury securities while the second invests both in those as well as other governmental issues. The third type of money market fund is by far the most common and the list of short-term securities that it can hold Treasury Bills, commercial paper, repurchase agreements, whiskey warehouse receipts, bankers’ acceptances, short-term CDs, eurodollars and other similar instruments with maturities of 120 days or less.

The fourth category is comprised of tax-free money market funds that invest solely in municipal offerings from a specific jurisdiction. The funds in the first two categories that invest solely in governmental securities can provide state-tax free income. As with any other type of fixed-income mutual fund. the yields that money market funds offer are closely tied to interest rates.

Pros and Cons of Money Market Funds

Money market funds offer several advantages that make them attractive for use as cash account vehicles. Unlike other types of mutual funds, they are completely liquid, and investors can draw cash out of them at any time in the same manner as they can with any other type of demand deposit bank account using checks or debit cards.

Money market funds also typically pay slightly higher interest rates than traditional savings and checking accounts, Tax-free money market funds can also offer an additional boost for those in the highest tax brackets who want to avoid generating further taxable income. There are also typically few or no fees or sales charges associated with these funds, and they can be bought and sold at any time in the same manner that money can be deposited and withdrawn from a bank or other savings account.

The biggest drawback that money market funds pose is simply that they offer very low returns compared to equities or other asset classes over time. Investors who keep cash in these funds for long periods of time risk missing out on more profitable rates of return elsewhere, and the rates of interest that they earn here will seldom outpace inflation. There have also been isolated incidents where money market funds have dropped below their $1.00 share price for at least short periods of time, although this has been very rare and only occurred in funds that were not housed in FDIC or privately insured accounts.

Some money market funds also require some sort of minimum deposit, such as $500 or $1,000. And while there are very seldom any transaction costs associated with money market funds, they do have expense ratios like any other fund, although they are usually very low (somewhere below 0.5% in most cases).

Common Uses of Money Market Funds

Most banks and other financial institutions use money market funds as “sweep” accounts that hold cash for clients. Any deposits, sales proceeds or other funds that are otherwise not being used are automatically swept into these funds to earn interest until they are needed. Most financial institutions specifically designate one or more money market funds to be used in-house as cash sweep accounts. Virtually every mutual fund company also has one or more of its own proprietary money market funds that are used for the same purpose.