Investing Options Series: Money Market Funds

Posted on 08. Jun, 2006 by in Saving & Investing

I decided to kick off the Investing Options Series by highlighting Money Market Funds. There’s really no rhyme or reason behind it except that the next installment will be about Money Market Accounts and highlighting the difference between the two Money Market Accounts. If you have any suggestions for future installments of the Investing Options Series be sure to let me know.

What Are They?
A Money Market Fund (not to be confused with a Money Market Deposit Account) is a type of mutual fund that maintains its value by purchasing short-term investments (maturing in less than one year) such as Treasury bills, short-term certificates of deposit (CDs), and short-term commercial debt. Money Market Funds are required by law to provide a safe and liquid investment while at the same time providing returns slightly higher than a run-of-the-mill passbook savings account. Money Market Funds are becoming increasingly popular and more widely available every year. Even PayPal has a Money Market Fund! In fact, at the end of 2003, money market mutual funds had nearly $2.3 trillion in assets, or 36% of the $6.39 trillion invested in all mutual funds, according to the Investment Company Institute (ICI), an industry group that represents mutual fund companies.

What is the Investment Strategy?
As mentioned above, Money Market Funds’ main strategy is to preserve your invested principal by keeping the net asset value (NAV or share price) around $1. Although Money Market Funds are not insured by the FDIC, no retailer has ever lost money in a Money Market Fund – which has made Money Market Funds infamous for low-risk investing. In fact, there has been just one case of a money market fund “breaking-the-buck,” or dropping below its $1.00 share price. In 1994 an institutional money fund, Community Bankers U.S. Government Money Market Fund, liquidated at 94 cents a share due to extensive derivatives-related holdings.

Different Flavors
There are a number of different Money Market Funds mainly based on the type of short-term investments that are used as well as the amount of the fund that is used to invest in “illiquid” assets in order to try and earn a larger dividend. There are portfolios, for example, that only invest in T-bills or only invest in CDs and there are even state-specific portfolios. The type of underlying investment might not seem very important, but it impacts the yield percentage as well as the taxability of the fund.

Taxable Money Market Funds invest in securities whose income is not exempt from federal income taxes, including funds that invest principally in Treasury securities. Tax-exempt money market funds invest in short-term securities whose income is exempt from federal income taxes, such as bonds issued by state governments and municipalities. The yield on tax-free funds is normally lower than the yield on taxable fund which means that those in upper-income tax brackets will benefit the most from those tax-free funds. If you’re thinking about a tax-free fund take a look at your tax bracket, the state your in, and monitor the yields that are often more volatile in the tax-free funds.

In order to calculate the taxable-equivalent yield:

  1. Subtract your federal income tax rate from 100. For example, if you are in the 25% income tax bracket, the difference is 75. This figure is also called your reciprocal-of-tax-bracket.
  2. Divide the tax-exempt fund’s yield by your reciprocal-of-tax-bracket. If the yield on a tax-exempt fund is 1.8% and your reciprocal-of-tax-bracket is 75, the taxable-equivalent yield is 2.4%.

In other words, you would have to earn a yield of at least 2.4% on a taxable money market fund to make the taxable fund more attractive than the tax-exempt fund.

If your tax-exempt fund is also exempt from state income taxes, subtract your combined income tax rate from 100. For example, if your federal and state income tax rates sum up to 40% of income, your combined reciprocal-of-tax-bracket is 60.

Using the same formula, a 1.8% yield on the current tax-exempt fund has a combined taxable-equivalent yield of 3%.

Short or Long-Term Investment?
Definitely short-term! Money Market Funds are designed to be highly liquid – meaning that you could cash out in a matter of days. In fact, many investment firms allow you to write checks from your Money Market Fund or withdraw cash from an ATM.

Potential Risk
Since Money Market Funds are managed in such a way as to minimize risk, the biggest risk involved in investing in Money Market Funds is the risk that inflation will outpace the funds’ returns, thereby eroding the purchasing power of the investor’s money. Fidelity also mentions that the price of a Money Market Fund could decrease due to a decline in the credit quality of an issuer (i.e. The U.S. Government can no longer honor T-bills). And, as mentioned previously, a Money Market Fund is not a deposit at a bank and is therefore not insured by the FDIC.

Potential Return
Money market funds have an average return of 4 to 6 percent a year – rivaling your savings account and even most short-term CDs. PayPal’s Money Market Fund, which they claim is the country’s highest yielding, had a 7-day average yield of 4.73% as of the date of this post. The interest of a Money Market Fund is calculated daily, but only paid out at the end of the month unless you sell the fund, then it is paid at that time. The graph below shows an example of returns from the PayPal Money Market Fund which sweeps the leftover PayPal funds of investors into a larger Money Market Fund.
paypal_moneymarketfund.jpg

These returns can be compared to the U.S. Treasury bill return over the past few years:
moneymarketfund_v_t-bill.jpg

BankRate.com provides current Money Market Fund yields as well as graphs such as this one showing the yield comparison of the different flavors of Money Market Funds.
moneymarketfundreturns.jpg

Who is this a Good Investment For?
In short, Money Market Funds are great for individuals looking for a safe and liquid short-term investment. Money market mutual funds are often used by people with brokerage accounts as a short-term holding place for money that’s waiting to be invested in stocks, bonds or mutual funds. However, you must be aware of the expense ratio so that your interest revenue is not swept away from your brokerage firm.

If you’re looking to invest some cash for the short-term, Money Market Funds are an available option – but they are not the best option for most individual investors mainly due to the fact that other investment vehicles (CDs and Money Market Accounts) provide the same liquidity and safety while providing higher returns.

4 Responses to “Investing Options Series: Money Market Funds”

  1. john doe

    05. Nov, 2006

    thanks- very helpful info
    john doe

  2. money-saving-tips

    27. Apr, 2009

    That’s an interesting article. I just wondered if you could tell me where to find more info on this topic ?

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