Business Finances

What Are Money Market Funds and How Do They Work – 2021 Review

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Written by Quentin Hack

When we say money market funds, what we really think about are the small mutual funds. In the end, MMFs are variations of mutual funds. These funds focus on investing in short-term debt securities. Investments as these are usually considered low-risk by investors. In fact, among all other forms of earning money through investing, you won’t find any that carries lower risks.

The best part is that they manage to generate income continuously, which is impressive, considering that it is on par with regular interest rates. All of your payments, when it comes to tax, are tied to the investments of the entire fund so that they can be tax-exempt or taxable. People turn to money market funds as they’re always liquid funds because they’re used by investors focused on short-term savings and cash managing.

How Do Money Market Mutual Funds Work?

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If you ever come in touch with mutual funds, this one won’t be too hard to understand. These funds consist of securities, which constitute a significant part of their portfolios. Their business starts by selling shares of these securities to investors, which, if successful, results in incoming money and capital gains. MMFs mostly work with cash, which most of these funds focus on in their portfolios. Still, they also focus on similar assets such as CDs (certificates of deposit), commercial paper, bankers acceptances, US Treasuries, and repurchase agreements. All of these are considered as cash equivalents on the financial markets.

In most cases, these funds are shared in three groups. The difference is that they separately invest in different types of securities. Like we already said, they tend to work with guarantees but are not shy of supporting and working with cash and its equivalents. The three groups we mentioned are:

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  • Government money market funds revolve around government Treasuries that are usually short-term. Here we are talking about notes and bills. But, if you are for it, you can also buy bonds and repurchase agreements. It all comes to what you want to include in the contract.
  • Prime money market funds are investments into banker’s acceptances, corporate papers, bank debt securities, and of course, short-term corporate notes.
  • Municipal money market funds are tied to municipal bonds and various other debt securities. The best part with municipal money market funds is that they’re free of federal income taxes, and in some cases, even from state income taxes. If you are willing to go beyond these three types, you are free to read more and do so.

If you opt for any of the types we suggested, you need to know that there is a possibility that you are going to face high minimum investments. The reason is simple. Not all investments are designed for retail investors. Some of them aim at institutional investments. What you can look forward to is the tax exemption, which is a frequent occurrence because money market funds invest in debt instruments.

The regular income depending on the type of security, can create this. But, in some cases, the tax is standard as it comes. These funds tend to focus on net asset value. Traditionally this value is set at $1. The difference between net asset value and the price of the share is what creates the income. Those who invest in this type of portfolio can be satisfied with the earnings. All investments are always at your reach, and you are the one influencing the risks. But, while there is a risk, MMF is considered one of the safest investments on the market. Compared to the novelties such as cryptocurrencies, they are static when it comes to volatility.

Advantages of Money Market Funds

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The most significant advantage and the one most younger and experienced investors love to see is the stability. Yes, money market funds are very stable. In fact, they’re seen as one of the soundest investments out there.

The reasons behind this are simple and understandable – MMFs are almost nonvolatile and tend not to react too much to market fluctuations. In addition, they are far more liquid than any comparable investments on the market. This happens because you can quickly withdraw your funds at any time and invest them somewhere else.

Another very positive aspect is diversification. This is followed by the fact that the securities you invest in are exempt from taxes; you can earn enough to pay your taxes.

Disadvantages of Money Market Funds

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This is where things can get tricky if you don’t grasp the situation wholly. Money market funds are investments, after all. You need to understand they’re not saving accounts. What this translates to is that you can trade them, buy and sell, but there’s no guarantee you’ll have any income.

Also, while their minimal risk involved, it doesn’t mean there aren’t any. Of course, there is, and what this means, that you can lose money on the money market funds. Investors have the lowest income rates when the interest rates are low because that’s when money market interests are also intense. If you are looking to be a long-term investor, these are not the markets for you. Even when the interest rates are higher, the MMF can get ahead of the inflation. This is why you need to look at it only as a short-time investment.

In the end, we left the part you might not like – the fees. They’ll come your way in the form of expense ratios. Your returns are going to be much lower when there’s a high ratio involved. When you combine your low returns with low-interest rates, you can lose your funds in the money market funds—this something you need to be aware of before partaking in this adventure. Now you know all the risks and advantages and disadvantages, all that is left is to decide if this is your cup of tea. Think wisely, and good luck investing.

About the author

Quentin Hack