It’s not overselling it to say the money market is one of the foundations of the whole financial system. However, not a lot of people understand or even know about it.
The money market is where we make large volumes of purchases and sales of short-term debt products. This market is famous for the security and liquidity it provides.
As a result, this market is also an excellent venue for investors who want those two things. Are you looking for a safe and liquid investment vehicle? Check out money market funds.
What are Money Market Funds?
If you’ve been dabbling in financial markets for some time now, you’ve probably heard about mutual funds. It’s where many different investors pool their money together while a fund manager invests the fund into various stocks, bonds, currencies, and other assets.
Well, a money market fund is a type of mutual fund, developed in the 1970s as an opportunity to invest in highly liquid instruments. We’re talking about assets like:
- Cash
- Cash equivalents
- Debt-based securities (only those with high ratings and short-term maturity of less than a year)
This pool of securities generally provides higher returns than interest-bearing bank accounts. Thus, such funds are highly liquid and sport low levels of risk.
Money Market Fund vs. Money Market Account
But you shouldn’t confuse this fund with a money market account. Remember that these two are entirely different things.
A money market fund is an investment. Behind it, there’s an investment company, so you get no guarantees that you’d get your capital back.
A money market account, meanwhile, is a savings account from financial institutions. There is interest that you can earn, and also get some transaction privileges. The Federal Deposit Insurance Corporation (FDIC) also insures the account. Essentially, that means you’re always going to get a portion of your money back no matter what happens.
Types of Money Market Funds
There are different types of money market funds. Being mutual funds, they are categorized based on the types of assets in which the fund is invested, the maturity period and other attributes.
For instance, a government money market fund has 99.5% of its assets in a mix of cash, government assets, and fully collateralized repurchase agreements.
A treasury fund, meanwhile, invests in U.S. Treasury debt securities like T-bills, T-bonds, and T-notes. There’s also a tax-exemption fund, which gives earnings minus the U.S. federal income tax.
Apart from these, there are many other reasons to invest in money market funds. For example, when the market gets very shaky and volatile, you can park your money on money market funds. Stocks and bonds can fluctuate in value wildly, but money market investments usually stay put.
Moreover, for the guarantee that money market funds do not invest in long-term investments, the Securities and Exchange Commission (SEC) requires the average maturity period to be less than 90 days. As a result, it is considered to be safe because investments have a short duration that decreases the risk of losing money.
Taxable and Tax-Free Money Market Funds
As previously mentioned, there are two categories of Money Market Funds: Taxable and Tax-free. It depends on the types of securities in which funds are invested
Taxable Funds are mainly invested in agencies of government, U.S Treasury securities, commercial papers repurchase agreements, and banker’s acceptances.
Tax-free Fund investments are short-term obligations imposed by municipal securities and have a lower income. In some cases, investors can buy Tax-free funds that are free from the state as well as from the local taxes. But, these types of exemptions are exceptional cases.
Sometimes beginner investors are struggling about deciding between tax and tax-free funds. However, there is no primary answer to the question of whether the first one is better or not. Usually, taxable funds pay higher earnings, but it doesn’t generally make it the best deal. Because, if the tax on those returns takes the additional profit, the better choice becomes a tax-free fund.
To compare these two fund earnings, you will need to do some mathematical calculation by converting the Tax-free yields into a taxable equivalent yield. To put it more clearly, the Taxable Equivalent Yield equals Tax-Free Yield divided on one minus Marginal Tax Rate. The following formula gives you the exact answer of which one will give you a bigger return in a particular situation:
Taxable Equivalent Yield = Tax-Free Yield / (1- Marginal Tax Rate)
Disadvantages
Of course, there are some downsides, too. For instance:
- Your purchasing power can be eroded because the rate of return you’ll get is maybe a lot slower than the inflation rate.
- Sometimes, there are annual fees. Such fees can eat away from the 2% to 3% interest you get from the fund.
- Of course, the elephant in the room, is that these funds aren’t insured by the FDIC, so you’re not going to have any chances of getting your money back should the fund go belly up.
Nonetheless, money market funds are still highly recommended for investors who want to control the risks they’re taking. They’re highly secure, highly liquid, and highly trusted by many investors.
