What are money market funds?
A money-market fund is a very low-risk type of mutual fund, meant to be as close to cash as possible while still earning a modest return. It is different from a money-market account, which is a type of deposit account in which the entire principal is invested in money-market funds by the bank. One key difference is that money-market accounts are FDIC-insured, while money-market funds, like all mutual funds, are not.
Money-market funds are meant to be very “liquid,” meaning they are easier to cash out at any time without expecting a loss, and thus are used for many short-term savings needs:
- an emergency fund
- a savings account for a down payment for a house
- a college fund for teenagers
- a savings fund for travel or other near-term needs
- a “parking place” for money while you decide how to invest it
The investments that make up a money-market fund are “cash and cash equivalents.” These are limited to highly rated debt issues (think AAA and AA) that mature in 13 months or less. Typically, money-market funds are mostly invested in U.S. treasury bonds, CDs from highly rated U.S. and foreign banks, and commercial paper (similar to bonds, with much shorter maturities, and usually issued by banks or very highly rated companies).
A money-market fund is an investment choice you can make in most retirement accounts, including IRAs. Many retirement savings accounts, especially those managed on behalf of employees — 401(k) accounts and the like — make the default investment into money market funds. These default investments are made for funds that allow participants to make decisions about where to invest, also known as “elections.” If you don't make an election, the fund manager is required to put your money into something relatively safe with at least a small expected return.
The average annual growth for money-market funds tends to be at the low end of the spectrum, a reflection of the low risk associated with these funds. The Fidelity Cash Reserves Fund, one of the largest such funds available, shows historic annual returns between a low of 0.02 percent (2010) and a high of 4.97 percent (2007) over the past decade — comparable to the interest rates in an ordinary bank savings account.
Loss of principal is rare
Money-market funds are meant to maintain “nominal value” — in other words, the principal value is never expected to fall. If you have a $1,000 investment in a money-market fund, your account balance should never fall below $1,000. If it does, it's called “breaking the buck” and it's very rare. It has happened recently, though: in 2008, during the financial crisis, the Reserve Primary Fund became “illiquid” (it was unable to issue cash to investors who asked to withdraw their money) because it was invested in securities issued by the ill-fated Lehman Brothers. Even these investors eventually recovered 98 cents on the dollar.
Money-market funds are mutual funds, but most mutual funds hold at least a portion of their portfolio in money-market funds, given their relative safety.