What money market mutual funds invest in

A money market mutual fund is a fund that holds short-term debt securities — mostly government bills, corporate debt that matures in less than a year, and certificates of deposit from banks. The fund manager buys these securities and divides ownership into shares that you can buy. When those securities mature or pay interest, the fund distributes the earnings to shareholders.

Money market funds are designed to be stable in value. Most aim to keep the share price at $1.00, though this is not may provide. Because the underlying securities are short-term and low-risk, the fund's value does not swing the way a stock fund does. The tradeoff is that the interest rate you earn — called the yield — is typically lower than what you would get from a bond fund or stock fund.

These funds sit between a savings account and a bond fund in terms of risk and return. A savings account is safer but pays almost nothing. A money market fund pays more but carries slightly more risk. A bond fund pays more still but can lose value if interest rates rise.

Key Takeaways

  • Money market mutual funds hold short-term debt securities like Treasury bills and commercial paper, not stocks or long-term bonds.
  • The yield on a money market fund changes daily based on current interest rates and the securities the fund holds.
  • Money market funds are not insured by the FDIC, unlike bank savings accounts, so there is a small risk of losing money.
  • You can buy and sell shares of a money market fund through a brokerage account, and most funds allow you to write checks or make transfers directly from the fund.

How the yield is calculated and what it means

The yield on a money market fund is expressed as a percentage and changes daily. It reflects the interest rate the fund earns on its holdings, minus the fund's operating expenses. If the fund holds securities paying 5 percent and the fund charges 0.25 percent in annual fees, the yield to you is roughly 4.75 percent.

The yield is not locked in. As securities in the fund mature, the manager reinvests the money in new securities at whatever current interest rates are. If interest rates fall, the fund's yield falls. If rates rise, the yield rises. This is different from a bond fund, where the value of existing bonds falls when rates rise.

The yield you see quoted is usually the seven-day yield, which is the annualized return based on the past week's earnings. It gives you a sense of what you might earn over the next year if rates stay the same, but rates rarely do.

The difference between government, prime, and tax-exempt money market funds

Money market funds come in three main types, and the type determines what securities the fund holds and who might benefit from it.

Government money market funds hold U.S. Treasury bills, Treasury notes under one year to maturity, and securities backed by federal agencies. These are the safest type because they are backed by the U.S. government. The yield is usually the lowest of the three types.

Prime money market funds hold corporate debt, bank certificates of deposit, and other short-term commercial paper. They pay a higher yield than government funds because corporate debt carries more risk than Treasury debt. Prime funds are still considered low-risk, but there is a small chance a company could default.

Tax-exempt money market funds hold short-term municipal bonds — debt issued by states, cities, and local agencies. The interest you earn is not subject to federal income tax, and sometimes not to state income tax either if you live in the state that issued the bonds. These funds make sense only if you are in a high tax bracket and live in a state with high income tax.

How money market funds differ from money market accounts

A money market account is a bank product, not a mutual fund. It is a savings account that pays interest and usually requires a higher minimum balance than a regular savings account. Money market accounts are insured by the FDIC up to $250,000, so your principal is protected if the bank fails.

A money market mutual fund is not a bank product and is not FDIC-insured. If the fund company fails, your money is not protected by federal insurance. However, money market funds are regulated by the Securities and Exchange Commission and held by a custodian separate from the fund company, so the risk of losing money to company failure is very low.

Money market accounts usually pay less interest than money market funds because banks want to keep the money on deposit. Money market funds often pay more because they invest in higher-yielding securities. The tradeoff is that a money market account is safer and more liquid — you can withdraw money when ready — while a money market fund takes one to two business days to settle.

Fees and expenses you will encounter

Money market funds charge an annual expense ratio, which is a percentage of your investment deducted each year to cover the fund manager's salary, administrative costs, and other operating expenses. Expense ratios for money market funds typically range from 0.10 percent to 0.50 percent per year, though some funds charge more and some charge less.

A lower expense ratio means more of the fund's earnings go to you. Over time, small differences in fees add up. If two funds have the same yield but one charges 0.15 percent and the other charges 0.50 percent, you will earn 0.35 percent more per year in the cheaper fund.

Some money market funds have a minimum initial investment, often $1,000 to $3,000, though some have no minimum. Check the fund's prospectus — the legal document that describes the fund — to see what the minimum is and what fees explore.

When money market funds make sense in a portfolio

Money market funds are useful for money you need to keep safe and accessible but do not need when ready. Common uses include holding an emergency fund, parking money between investments, or storing cash you plan to spend within the next year.

Because the yield is low compared to stocks and bonds, money market funds are not meant to be a long-term investment for retirement or wealth-building. If you have money you will not need for five or more years, a bond fund or stock fund will likely earn more over that time.

Money market funds can also serve as a buffer during market downturns. If stock prices fall sharply, some investors move money into money market funds temporarily to avoid locking in losses. This is a way to hold cash while waiting for prices to recover, though it means missing any gains if the market rebounds quickly.

How to buy and sell shares of a money market fund

You buy money market fund shares through a brokerage account — either at a bank, an online broker, or an investment firm. You choose the fund you want, decide how much to invest, and place an order. The purchase settles in one to two business days, and the money is then invested in the fund's securities.

To sell, you place a sell order through the same brokerage account. The fund redeems your shares at the current share price (usually $1.00) and the money appears in your account within one to two business days. Some money market funds allow you to write checks directly from the fund or transfer money electronically, which makes them function almost like a checking account.

There are no capital gains taxes when you sell a money market fund share at $1.00 because there is no gain. You do pay income tax on the interest the fund earned while you held it, just as you would on interest from a savings account.

Frequently Asked Questions

Can a money market fund lose value?

Yes, though it is rare. Most money market funds aim to keep the share price at $1.00, but this is not may provide. If the securities in the fund default or interest rates fall sharply, the share price can drop below $1.00. This happened to a small number of funds during the 2008 financial crisis. The risk is very low with government money market funds and slightly higher with prime funds.

Is a money market fund the same as a money market account?

No. A money market account is a bank savings product insured by the FDIC. A money market mutual fund is an investment product not insured by the FDIC. Money market funds often pay higher interest but carry slightly more risk. Money market accounts are safer but usually pay less.

How often does the yield change?

The yield changes daily as the fund's holdings mature and are reinvested at new interest rates. The seven-day yield you see quoted is updated daily and reflects current market conditions. If you hold the fund for a year, your actual return will depend on the yields during each day you owned it.

Do I owe taxes on money market fund earnings?

Yes. The interest you earn is taxed as ordinary income at your federal tax rate. If you hold a tax-exempt money market fund, the interest is usually not subject to federal income tax. State income tax treatment depends on the fund and your state.

What is the minimum investment for a money market fund?

Minimums vary by fund and by brokerage. Some funds have no minimum, some require $1,000, and some require $3,000 or more. Check the fund's prospectus or the brokerage website to see what the minimum is for the specific fund you are considering.