A Beginner’s Guide to Money Market Funds: Understanding Benefits, Risks and How to Invest in 2021

I. Introduction

If you’re new to investing, the world of finance may seem overwhelming. However, you don’t need an advanced degree in economics to understand the basics of money market funds. A money market fund is a type of mutual fund that invests in short-term, low-risk fixed-income securities, such as treasury bills, certificates of deposit, and commercial paper.

This article aims to provide a beginner’s guide to money market funds. We’ll explain the basics of this type of investment, the benefits and risks it can offer, and how it might be the perfect fit for your investment portfolio.

II. A Beginner’s Guide to Money Market Funds: Understanding the Basics

Money market funds are designed to be a safe and liquid way to invest your cash reserves and earn a reasonable interest rate, while preserving your principal investment. There are three main types of money market funds:

Government money market funds: invest in short-term securities issued by the US federal government and agencies.
Retail money market funds: invest in securities issued by corporations and other non-government entities with high credit ratings.
Institutional money market funds: invest in securities that are not available to retail investors, such as commercial paper issued by large corporations.

These funds aim to maintain a stable net asset value (NAV), which means that the share price should always be $1.00. In other words, you invest $1 and get $1 back, plus the interest earned, which is paid out periodically.

Money market funds operate by pooling together the investments of many individuals and institutions. Fund managers then use this pool of cash to purchase a diversified portfolio of short-term debt securities, such as treasury bills and commercial paper. Since these investments are short-term, the fund’s portfolio turns over quickly, which enables the fund to quickly adapt to changing market conditions while maintaining stability.

III. Why Money Market Funds Might Be the Perfect Investment for You

Money market funds can offer a number of benefits as part of your investment portfolio:

Liquidity: Money market funds are highly liquid and can be easily converted to cash, which makes them an attractive option for short-term investments or as a place to park cash reserves.
Low risk: Money market funds are considered low-risk investments because they invest in low-risk, short-term securities. The investment risks are mainly tied to interest rate fluctuations and the underlying credit quality of the underlying investments.
Flexibility: Money market funds can be a standalone investment or can be part of a diversified portfolio of investments. Investors can choose the underlying investments based on their personal financial goals and risk tolerance.

Money market funds can also be used to complement riskier investments like stocks or bonds. A well-diversified portfolio may include money market funds as a lower risk component. For example, an investor may keep a portion of their portfolio in money market funds to provide access to liquidity in case of market downturns, while allowing higher risks investments to continue generating returns in an upward market.

IV. The Risks and Rewards of Investing in Money Market Funds

While money market funds are low risk, investors should be aware of the potential risks:

Interest rate fluctuations: Any fluctuation in interest rates can impact the returns of a money market fund. Fund managers adjust the fund holdings to maintain interest rate sensitivity, but returns may be lower than expected in a rising interest rate environment.
Credit quality: Money market funds may experience losses if a significant portion of the underlying investments defaults or has its credit rating downgraded.
Inflation risk: The returns earned by a money market fund may not keep up with inflation, which could erode the purchasing power of the invested money over time.

The rewards of investing in a money market fund represent the potential return on investment:

Yield: Money market funds can offer investors a higher yield than they might be able to earn with a savings account or other risk-free investment. While the interest rates offered by money market funds are not as high as riskier investments like stocks, bonds, or real estate, they offer a reasonable return while preserving capital.

Investors should be mindful to diversify the risk across different categories and maturities of securities to avoid any concentration of risk.

V. How to Compare Money Market Funds: Factors to Consider before Investing

When choosing a money market fund, there are a few key factors to consider:

Expenses: Check the expense ratio of the fund to make sure it is low relative to the yields, as higher expenses can decrease your overall return.
Yield: The yield of a money market fund can vary depending on fund’s investment strategy, fee policy and financial environment. Look for funds that offer competitive yields while keeping pace with the market conditions.
Credit quality: Money market funds that invest in more highly-rated securities will be less risky, however, they may offer lower yields. Look for funds that also invest in securities that align with the fund’s objectives and risk tolerance level.
Liquidity: One feature that makes money market funds attractive is their ability to offer investors liquidity, so funds that offer high levels of liquidity may be more suited to investors with an urgent need for cash at short notice.

To compare funds, investors can do research on the internet and check the funds websites or Morningstar. These platforms offer detailed information on funds, including fee structures, holdings, maturity, and credit rating.

For example, if an investor were to evaluate two government money market funds with similar investment objectives, they might look at the expenses, yield and credit quality of each of the funds.

VI. The Top 5 Money Market Funds to Consider in 2021

So, with all of the above in mind, which money market funds might be the best fit for your investment portfolio? Consider these five options:

Vanguard Prime Money Market Fund: With over $185 billion in assets under management, this retail money market fund from investment giant Vanguard has an expense ratio of 0.16% and a yield of around 0.1%.
Fidelity Government Money Market Fund: This institutional government money market fund from Fidelity has an expense ratio of 0.16% and yields around 0.03%, with a stronger focus on liquidity.
Schwab Government Money Fund: Schwab’s fund focuses on high credit quality US government securities, helping to keep the risk down. It has an expense ratio of 0.10% and a yield around 0.02%.
iShares Short Treasury Bond ETF: This ETF invests in short-term US Treasury securities, which provides the potential of higher returns than other government money market funds. Expense ratio is 0.15% while yield is around 0.04%.
PIMCO Select Govt MMF: This institutional fund features government and related securities, along with its low expense ratio of 0.10% and a yield around 0.04%.

VII. Money Market Funds vs. Savings Accounts: Which is the Better Option for Short-Term Investing?

Finally, should you be investing in a money market fund or simply keeping your money in a savings account? Here are some pros and cons to consider:

Interest rates: Money market funds can offer higher yields than savings accounts.
Insurance: Deposits held in savings accounts are often insured, whereas money invested in a money market fund is not. However, for US government securities money market funds, insurance coverage may apply for underlying investments under certain circumstances.
Risk: Money market funds carry a lower level of risk than other types of investments, including stocks, bonds, and mutual funds.
Accessibility: Money market funds can be accessed easily, meaning if you require access to cash quickly, you can typically access your funds within one to two business days.

Ultimately, which option suits an individual depends on their specific requirements and financial situation. One may choose a money market fund option as a temporary investment vehicle to access a higher yield potential than the savings account for short-term funds.

VIII. Conclusion

Money market funds can offer investors many advantages – a lower degree of market risk, competitive returns, and accessibility, to name a few. However, before investing, it is important to understand their benefits and risks and how they compare to other investment options, such as savings accounts. Investors should always carry out their own research before investing in money market funds and evaluate the scope of associated risks they are comfortable with.

If you’re interested in investing in money market funds, consider all of the above information to make an informed decision when selecting the right money market fund for your individual investment goals and risk tolerance level.