What is a money market fund?

Key points

• Money market funds offer investors a liquid and low-risk way of earning interest.
• Common types of money market funds include government, prime, Treasury and tax-exempt.
• Money market funds are considered safer and less volatile investments.

What is a money market fund? And how does it work?

A money market fund is a type of mutual fund that invests primarily in short-maturity, high-quality fixed-income securities. 

Fixed-income securities are debt instruments that pay fixed amounts of interest referred to as coupon payments.

When you buy a money market fund, you earn periodic interest payments. The yields depend on interest rates at the time. 

Here are some general facts about money market funds: 

• Money market funds debuted during the 1970s as high-yield alternatives to traditional bank savings accounts. 

• The goal of a market fund is to pay investors with interest while insulating them from market fluctuations.

“These funds have a three-part mandate: to provide the highest rate of interest, keep prices stable and maintain a high level of liquidity,” says Patrick Marcinko, associate financial advisor at Bogart Wealth. 

Like all mutual funds, a money market fund has a net asset value, or NAV, which is its total assets minus its total liabilities. You can calculate the NAV of a single share by dividing the fund’s NAV by the number of outstanding shares.

A money market fund calculates its NAV at the end of the trading day. Most money market funds attempt to maintain a NAV per share of $1. That provides stability, unlike stock and bond funds, which can experience high day-to-day fluctuations in NAV.

Money market fund risks

But money market funds are not risk-free investments. 

“During periods of severe market stress, a money market fund could ‘break the buck,’ meaning that its NAV per share temporarily falls below $1,” says Cassandra Kirby, chief operating officer, chief compliance officer and private wealth advisor at Braun-Bostich & Associates. “However, this type of situation is very rare, with the most recent instance occurring in 2008 after Lehman Brothers declared bankruptcy.” 

After the 2008 financial crisis, the Securities and Exchange Commission issued regulatory reforms for money market funds in 2010 and 2014 to further reduce credit and liquidity risks. 

Notable reforms include:

• Liquidity fees and redemption gates: During a market crisis, money market funds can charge fees on redemptions or suspend redemptions temporarily, imposing a “gate” that blocks access to shares.

• Permanent suspension of redemptions: In times of severe market stress, money market funds can cease redemptions altogether and close.

Both measures are intended to reduce the chances of a “run on the fund,” which is caused when investors flock to panic sell and can contribute to breaking the buck. 

Types of money market funds

From a regulatory perspective, money market fund types can be distinguished by their intended end buyers, who could be retail investors or institutional investors. 

Retail investors invest their own money for goals like wealth building and retirement. Institutional investors are companies or organizations that pool and invest money on behalf of other people. As a retail investor, you generally cannot access institutional money market funds, as they often impose hefty minimum investment requirements and are governed by different regulations. 

There are a number of different types of money market funds, too.

1. Government money market fund

Government money market funds must invest at least 99.5% of their assets in cash, government securities, U.S. agency debt or repurchase agreements collateralized by either Treasurys, U.S. agencies or U.S. agency mortgage-backed securities.

The agencies typically include government-sponsored enterprises like Fannie Mae, Freddie Mac and the Federal Home Loan Banks system. But these securities are not issued by the U.S. Treasury.

2. Prime money market fund

Prime money market funds invest in dollar-denominated money market instruments. A few types include commercial papers issued by corporations and government-sponsored entities, corporate notes and certificates of deposit (CDs).

“Due to the higher credit risk of these assets, prime money market funds are considered to be moderately riskier than government money market funds but can pay higher yields,” says Nafis Smith, senior portfolio manager and head of taxable money markets at Vanguard. 

3. Treasury money market fund

U.S. Treasury money market funds invest in low-risk, very liquid investments like U.S. Treasury bills. These funds can provide investors with a steady, stable investment. With these funds, typically at least 99.5% of the funds assets are in cash, U.S. Treasury securities or repurchase agreements collateralized by U.S. securities. There are also some Treasury-only funds.

4. Tax-exempt money market fund

Tax-exempt funds, also known as municipal money market funds, invest at least 80% of assets in municipal securities that are shielded from federal income taxes. You can also opt for state municipal funds, and the same rule of at least 80% of assets being exempt from federal personal income tax applies. 

“Tax-exempt money market funds are suitable for investors in higher income tax brackets who are investing outside of a tax-sheltered account like a Roth IRA,” says Herman Thompson Jr., certified financial planner at Innovative Financial Group. 

Pros and cons of money market funds

Like all investments, money market funds have advantages and disadvantages. When deciding whether a money market fund is suitable, investors should consider the following:

Pros

• Low risk: Money funds are generally less risky than stock and bond funds, given that federal regulations require that they invest short-term, high-quality investments. The NAV of a money market fund is designed to remain stable, unlike stock and bond funds, which can experience high volatility. 

• Liquidity: Your investment in a money market fund is generally accessible and can be bought and sold easily within a brokerage account. That differs from bank savings products like CDs that impose lockup periods, which can range from six months to five years.

• Tax-efficiency: Income generated by market mutual funds can carry some tax-exemptions, depending on securities that the fund invests in.

Cons

• Interest rate risk: Money market funds provide income at prevailing short-term interest rates. As a result, there is a chance of income falling sharply during periods of low interest rates. If interest rates fall enough, the yield of a money market fund can be eaten up by fund fees. 

• Credit risk: During the great financial crisis of 2008 to 2009, some money market funds “broke the buck” when their NAV per share dropped to less than $1. The risk is higher for prime money market funds that hold nongovernment securities. Unlike bank deposits, money market funds are not insured by the Federal Deposit Insurance Corp. (FDIC). 

• Inflation risk: Because of the short-term, low-risk nature of money market funds, their returns are typically lower than stock and bond funds. There is a risk that the returns of money market funds may not outpace the eroding effects of inflation over the long term.

Pros and cons of money market funds

PROS	CONS
Lower risk and volatility than stocks and bonds.	Yields can fall when interest rates are low.
High liquidity and access to money.	Credit risk during times of market stress.
Some funds have better tax-efficiency.	Inflation can eat away at returns over time.

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Are money market funds safe?

Compared with stocks and bonds, money market funds are much less volatile. But they are not completely risk-free.

Historically, there have been times during market crises when investors in money market funds suffered a loss of principal. Unlike savings accounts, money market accounts and CDs, an investment in a money market fund is not insured by the FDIC.

Frequently asked questions (FAQs)