A Beginners Guide to Investing in Money Market Fund: Definition, Risks, and Benefits
What is a Money Market Fund?
A money market fund refers to a type of fund that investors use to low-risk holdings in a portfolio. It can be said to be a type of mutual fund that invests in highly liquid and low-risk short-term debt securities. Money market funds are arguably one of the low risks investments that you can choose to work with. They usually generate income for investors at their par value with short-term interest rates. Money market funds could either be taxable or nontaxable. It all depends on the type of investment that the fund holds. One of the most definitive features of money market mutual funds is their high liquidity. For this reason, they are used by investors for cash and short-term saving.
The highly liquid or near-time instruments associated with money market funds include; cash and cash equivalents and debt-based securities. Money markets funds are also called money market mutual funds. It is essential to note this so that you do not get confused whenever someone uses any of these terms.
Now that you understand what money market funds are let us look at how they work.
How does Money Market Fund Work?
Like all other mutual funds, money market funds work by assembling a portfolio of securities and selling shares to investors. The investors then earn a return in the form of capital gains and incomes. In other words, money market funds issue redeemable units of shares to shareholders or investors. The investors must follow a specific guideline as set by financial regulators such as the US Securities and Exchange Commission. The following are some of the debt-based financial instruments that a money market fund can invest in;
· Commercial papers
· Repurchase agreements
· Treasury bills which are short term debt issues to the government
· Certificate of deposit
· Bankers’ acceptance
The returns that come from the above instruments usually depend on the prevailing market interest rates. As such, the overall returns from the investment in money market funds also depend on the prevailing market interest rates. Let us now look at the different types of money market mutual funds.
Types of Money Market Funds
There are various categories of money market funds. They are usually classified depending on the class of invested assets the period to maturity, among other attributes. Each type invests in different types of securities. Additionally, they also invest in cash and cash equivalents. The following are the major types of money market mutual funds:
1. Government Money Market Funds
Government Money Market Funds purchase short-term government treasuries. The treasuries usually include treasury notes and treasury bills but might also include repurchase agreements and treasury bonds. The government Money Market Funds typically take up to 99.5% of the total assets in cash. The instruments are usually collateralized by cash or government securities.
2. Prime Money Market Funds
A prime money Market Fund usually invests in a floating-rate debt or a corporate paper on assets that are non-treasury. Others include bank debt securities and banker’s acceptances.
3. Tax-exempt Money Market Funds
A tax-exempt Money Market Fund is a special Money Market Fund that offers earnings that are entirely free from federal income tax as imposed by the US. Federal government. In some instances, the tax-exempt Money Market Funds can also be exempted from state income taxes. Municipal Money Market Funds primarily fall under this category.
Why use Money Market Fund?
There are several factors that play in favor of the Money Market Fund, which makes it a lucrative investment. In this section, we are going to look at some of the advantages of using Money Market Funds.
1. Lower Risks
The first benefit of using Money Market Funds is that it has lower risks. Although these investments come with a small return, they are comparatively less risky than other investments. It is, therefore, an ideal investment option for the risk-averse.
It is the direct opposite of a stock investment. If you want to reduce the risks associated with other investments, such as stock investment, you can choose to switch to Money Market Funds or place some portion of your assets in the Money Market Funds.
2. Typical Liquidity
Another advantage that comes with using Money Market Funds is that the investments are highly liquid. It means that you can quickly get back your money within a few trading days and whenever you want the money. Usually, it takes a single trading day for a mutual fund sale to settle. After that, you can get your money in cash or in your account for spending.
Money Market Fund institutions usually allow the investors to write withdrawal checks to facilitate the withdrawal of funds from a Money Market Fund. As such, the investors get the advantage of dividend earnings as well as quick and easy access to cash. It is always essential to ensure that you ask your institution about the restrictions and fees that will be applied.
4. Responsive Rates
Money Market Funds tend to have lucrative rates that range from low to high over time, depending on the prevailing market conditions. Therefore, investing in Money Market Funds is an excellent idea since you can expect to make a catch whenever the rates rise. Additionally, because of the understandable trade-offs that exist between risk and return, you can always bet on the Money Market Funds to give you long time returns, although relatively low.
Potential Risks with Money Market Funds
Although Money Market Funds are lucrative investment ideas, they also come with potential risks, which should make a potential investor wary bout making rush decisions. The following are some of the risks associated with Money Market Mutual Funds.
1. You Could Potentially Lose Your Principal
The Money Market Fund manager will strive to keep the share price constant at $1 per share. However, there is no complete guarantee that the price of the share will remain stagnant forever. In case worse happens and the share prices drop, you could lose part or all of your principal depending on the level of the decline.
2. Money Market Funds are not FDIC Insured
Saving your money in a regular bank account is safe because the bank insures your assets for up to $250,000. If anything happens that compromises the money in your bank, you will not have a reason to worry because the insurance cover will compensate you for the loss. However, the case is a bit different with Money Market Funds. Although they have relatively low risks, there are still some risks that might occur to your funds. In a situation where the risk occurs, there is no government institution that will guarantee you compensation for the losses you will incur. This is something you should look at critically before dipping your toes in the Money Market Fund investment.
3. They are Characterized by Variable Rates
Money Market Funds are characterized by highly variable rates, making it difficult for investors to accurately estimate the level of returns. The rates usually keep on fluctuating up and down. The upward trend is usually a good sign, while the drop in the rates could mean you are bound to incur losses if things remain on that trend. The same risk is also common in other security investments, but it is worth noting if you are the kind of investor who goes for much predictable returns on their funds.
4. They come with opportunity Costs and Inflation Risks
Money Market Funds are generally considered to be less risky than other investments like equities. For this reason, they are associated with lower returns than long-term and riskier investments. Additionally, the inflation rates can eat away the returns that come with such investments. In the end, you virtually end up with nothing.
5. Money Market Funds Could Become Illiquid
Although rare, sometimes the Money Market Funds can become illiquid, thereby reducing problems that come with market turmoil. Funds could end up imposing liquidity fees which will require the investor to pay a cashing out fee. Additionally, they might also use redemption gates or temporary suspensions that will require investors to wait for long before receiving returns from Money Market Funds.
Wrapping it Up
Money Market Fund is a great investment option that you can choose to work with. This article has explained the idea of Money Market Fund, how they work, their advantages and disadvantages. It is now time to put this knowledge into practice by getting Money Market Funds. Luckily for you, there are many options at your disposal that you can choose to work with. For instance, there are plenty of brokerage houses and mutual funds companies that would be great for you. You can consider investing in some of them.