There are many investment options with a high potential for good returns in the short term. One of these investment options are money market funds. Money market funds are liquid short-term investments that play a useful role in any investment portfolio. If you want to include money market funds into your investment strategy, it is best to understand what money market funds are and their nature.
In this article, you will learn what a money market fund is, how it works, what it invests in, types of money market funds and risks of investing in money market funds.
What is a Money Market Fund?
A money market fund is a type of mutual fund that invests in highly liquid securities within a short term duration. Money market funds are relatively low risk and they pay out returns in form of dividends with other alternative payments.
Money market funds are offered by brokerages, banks, and mutual fund companies. By investing in short-term securities, money market funds aim to reduce uncertainty and control risk. Most money market fund securities reach maturity in under a year.
How Do Money Market Funds Work?
A money market fund works like a typical mutual fund. Money market funds assemble a portfolio of securities and sell shares to investors. These investors earn returns from the portfolio in the form of income and capital gains. Money market funds try to maintain a share price of $1 and they are required to purchase securities with maturities of 13 months or less, or 25 months for government securities.
The weighted average maturity of an investment fund’s portfolio should be 60 days or less. This helps to maintain the overall liquidity of money market funds and to ensure that your portfolio will not be tied up in long-term investments.
What Do Money Market Funds Invest In?
Money market funds generally invest in cash and cash equivalents whose returns are dependent on the applicable market interest rates. Some of these financial instruments include:
- Certificates of deposit (CDs). They are bank-issued savings certificates with short-term maturity.
- Banker’s acceptances (BA). BAs are short-term debts guaranteed by commercial banks.
- U.S treasuries. They are short-term government debt issues.
- Commercial papers. Commercial papers are unsecured short-term corporate debts.
- Repurchase agreements (Repo). Repo are short-term government securities.
Types of Money Market Funds
There are several types of money market funds, each classified depending on which kinds of securities it invests in, the maturity period, and other attributes. They include:
- Prime funds. They invest in floating-rate debt and commercial paper issued by companies, government-sponsored enterprises, and U.S government agencies.
- Government money fund. Money market funds that invest in cash and securities that are backed by the government such as repurchase agreements,
- Treasury fund. They invest in U.S treasury debt securities such as treasury bills, bonds, and notes.
- Tax-exempt money funds. They are typically made up of municipal bonds and are exempt from federal income taxes and in some cases state taxes.
Also read: Money market fund vs SACCO.
What are the Risks of Money Market Funds?
Every investment comes with its own risks. Although money market funds are relatively low-risk investments, they are not entirely risk-free. It is good to know the risks associated with money market funds before you can invest in them. The risks involved include the following:
1. Potential loss of investment. Every investment fund faces a potential risk of loss. Money market funds are investments and not savings accounts. As such, there is no guarantee of earnings and there is the possibility of losing your investment.
2. Expense Ratio. Money market funds have expenses and you will need to keep an eye on the funds you invest in. Funds with higher-than-average expense ratios are going to eat into relatively low returns.
3. Liquidity risk. Money market funds may impose a fee upon the sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below the required minimums.
4. Money market funds are not FDIC-insured. Money market funds are not covered by the FDIC’s federal deposit insurance and in case the financial institution you have invested your money in fails, you may not be able to claim your money back.
5. Foreign exposure. Entities that are located in foreign countries may be affected by economic, adverse political, regulatory, or market developments in these countries.
6. They are sensitive to interest rate fluctuations. With this, you do not know what the return on your investment will be. If the interest rate increases, it is beneficial to the investor. However, if it goes down, you may end up losing the value of your investment.
7. Increase in inflation. High inflation can diminish your returns over time. Besides, being highly liquid, money market funds do not fully eliminate the risk of losing money and paying higher fees. Sudden fund withdrawal may force you to pay a substantial amount just to cash out.
Summary of Money Market Funds and How They Work
If you decide to use money market funds as your investment vehicle, make sure you know about a particular money market fund including its characteristics, how its works, how its expenses compare to other investment vehicles, risks and its investment strategy. This way, you can avoid potential risks of investing in money market funds.