What kinds of money market funds exist?

Money market funds, a type of mutual fund, are designed to offer low-risk, liquid, and short-term investment opportunities. These funds are typically managed by companies that invest in various money market instruments, consisting mainly of highly rated securities. Investors can choose from different types of money market funds, including municipal funds, state-level debt funds, Treasury funds, and funds focusing on private commercial market exposure.

What Makes a Money Market?

A market is classified as a money market if it comprises highly liquid, short-term assets with maturities typically not exceeding one year. These assets can range from certificates of deposit (CDs) and Treasury bills (T-bills) to commercial paper and short-term securities loans. The Federal Reserve Board monitors money markets through its flow of funds survey, with money markets representing about one-third of all credit in the United States.

Money Market Funds

Developed in the 1970s, money market funds offer investors the opportunity to invest in a diversified pool of securities that aim to provide higher returns than traditional interest-bearing accounts with lower risk than stocks. With approximately $5 trillion in assets currently invested in money market funds, these investments typically include government securities, certificates of deposit, and other low-risk securities. While these funds strive to maintain a stable net asset value (NAV) of $1 per share, their yields may fluctuate, although losses for investors are rare. It is important to note that money market funds are not federally insured, but they are regulated by the SEC under the Investment Company Act of 1940.

Regulations govern that money market funds can only acquire short-term investments that can be fully redeemed within 397 days, with minimal credit risk and high credit quality standards akin to highly rated securities to safeguard investors.

U.S. Treasury Funds

U.S. Treasury funds primarily invest in treasury securities, offering lower yields compared to other money market funds but boasting the lowest risk profile. These funds are also tax-exempt, making them an ideal choice for risk-averse investors seeking slightly higher returns than traditional bank accounts.

U.S. Government and Agency Funds

U.S. government and agency funds invest in federally guaranteed bonds and notes, along with foreign market investments. While slightly riskier than U.S. Treasury funds, they offer marginally higher yields and are also tax-exempt.

Diversified Taxable Funds

These funds, which do not focus solely on government securities, may have higher expense ratios but potentially offer greater interest income. Investing in various commercial paper and deposits, diversified taxable funds carry more risk but also provide higher yields, with their income subject to taxation.

Tax-Free Funds

Tax-free funds specialize in tax-exempt securities issued by local and state governments. Exempt from federal taxes, these funds can be complex, with some restricted to single-state investments and considered the riskiest mutual fund option, best suited for high-tax bracket investors or those in high-tax states.

For example, T. Rowe Price offers a New York Tax-Free Money Fund, targeting exemptions from federal, New York state, and New York City income taxes, tailored for investors seeking tax efficiency.

The Bottom Line

While money market funds are considered safe investments, their long-term returns typically fall short of bonds and stocks. These funds are commonly used as cash management tools for investors awaiting suitable investment opportunities or seeking stability over aggressive growth. They can serve as an alternative to savings accounts in low-yield environments and may contribute to balanced asset allocation strategies.