Thomas Jefferson got it partly right when he stated, in the opening lines of the United States Declaration of Independence, that “all men are created equal.” He should have included “women,” but I digress.
Unlike all men and women, all money market funds are not created equal. It’s important that investors understand the differences.
Let’s start by looking at exactly what a money market fund is—and isn’t.
A money market fund is a mutual fund. It’s legally required to invest in “low-risk” securities. Money market funds pay dividends that usually reflect short-term interest rates.
Money market funds invest in government securities, certificates of deposit, and commercial paper of public companies. With rare exceptions, they keep their net asset value at a steady $1 per share, but there’s no guarantee it will not fall below that level. In fact, money market funds are prohibited by law from making such a guarantee.
Money market funds are legally required to redeem their shares within seven days of tender.
That’s the good news.
Here’s what money market funds aren’t:
They’re not insured by the Federal Deposit Insurance Corporation (FDIC) or otherwise. Treasury bills and deposits at banks covered by the FDIC are federally insured. The standard insurance amount for bank deposits is $250,000 per depositor. An investment that is federally insured is protected by the full faith and credit of the U.S. government. Money market funds do not have this protection. Investments in them carry additional risk.
Money market funds are also not insured by the Securities Investor Protection Corporation, which restores funds to investors with assets in bankrupt or financially troubled brokerage firms.
There are approximately 1,200 taxable money market funds and 800 tax-free funds. In order to assess the risk of a money market fund, you need to understand its underlying investments.
Of the 1,200 taxable money market funds, 500 invest solely in government securities. The balance can also invest in commercial paper. While both categories of funds are relatively low risk, the funds that confine their investments to government securities are lower risk than those that don’t.
If you are investing in a money market fund that invests in commercial paper, you should find out what percentage of its portfolio is invested in commercial paper and what percentage is invested in government securities. The higher the percentage invested in government securities, the lower the risk.
While money market funds are very low risk, recent experience shook the confidence of money market investors. In the fall of 2008, the Reserve fund became collateral damage for the subprime market fiasco. This fund was unfortunate enough to hold a significant amount of commercial paper issued by Lehman Brothers, which became worthless when Lehman declared bankruptcy. In the ensuing run on the fund, it “broke the buck,” meaning that every dollar invested in the fund was actually worth less than a dollar. The Treasury Department aggressively stepped in to restore confidence by announcing a temporary program to insure money market funds.
Investments in money market funds remain a solid choice for investors seeking higher yields than bank savings accounts and short-term certificates of deposit. Money market funds also provide excellent liquidity.
If you are considering a money market fund, look for one with rock-bottom expenses. Read the prospectus and review the investments in the fund. Stick to money market funds issued by major fund families, like Vanguard, Fidelity, and Charles Schwab.
Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, and The Smartest Retirement Book You’ll Ever Read. His latest book is Timeless Investment Advice.
Watch Dan on YouTube.
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