Money Market Funds Explained

A money market fund is a very low-risk investment, and the best comparison is a savings account. The level of risk is similar. It is considered a cash investment, which means the yield can change over time as interest rates fluctuate, but your principal generally does not. Unlike stocks or bonds, where values can go up and down, a cash investment like a savings account or money market fund is designed to maintain stability.

A money market fund is a type of mutual fund, similar in structure to a stock or bond mutual fund, but it invests in cash equivalents. Investors pool their money together to gain economies of scale, daily liquidity, and professional management. The fund typically invests in very short-term bonds, often lasting just a few weeks or months. Because these bonds are so short term, their value does not fluctuate much, which helps maintain stability of principal.

There are several types of money market funds. A prime money market fund invests in very short-term corporate bonds. A government or agency money market fund invests only in short-term government or agency securities. A Treasury money market fund invests exclusively in very short-term U.S. Treasury securities, which are generally exempt from state income tax. Treasury funds are considered slightly less risky than prime funds. There are also municipal money market funds, which invest in short-term municipal bonds. The income from these funds is typically exempt from federal income tax, making them attractive to investors in high tax brackets, even though the stated yield is often lower.

In practice, a money market fund works much like a savings account. You can put money in and take it out whenever the markets are open. Funds are typically linked to your bank account, and transfers usually take one or two days. Because they are safe and liquid, money market funds are commonly used for emergency funds, short-term savings, upcoming tax payments, or saving for a down payment within the next year or so.

The main alternative to a money market fund is a high-yield savings account. These are usually offered by online banks and typically pay much more than traditional local bank savings accounts. Most of the time, money market funds offer slightly higher yields than high-yield savings accounts, though there are periods when the opposite is true. One important difference is FDIC insurance. High-yield savings accounts are insured by the Federal Deposit Insurance Corporation up to $250,000 per depositor per bank. Money market funds are not FDIC insured, although they are covered by SIPC insurance, which works differently. Even without FDIC insurance, money market funds are still considered very safe due to their short-term holdings.

While it is theoretically possible to lose money in a money market fund, the likelihood is extremely low. There have been rare cases, particularly during the global financial crisis, when certain institutional money market funds experienced very small losses. For retail investors, the risk of a significant loss is very low. The bigger risk with any very safe investment, including CDs, savings accounts, and money market funds, is that returns may not keep up with inflation over the long term.

Opening a money market fund is straightforward. You can open a brokerage account at firms like Vanguard, Fidelity, or Schwab, link your bank account, and select a money market fund as your investment. Often, the default holding for uninvested cash in a brokerage account is a money market fund. While it is not as convenient as a checking account for everyday transactions, it is an excellent place to keep cash that you do not need immediately but still want to keep safe while earning a competitive yield.