A silver lining of recent interest rate increases is the ability to earn some level of interest on cash balances.

When reviewing the various options with a client recently, she asked what exactly a money market fund was and whether there were any risks associated with this investment vehicle. Let’s take a closer look at this great question

What is a money market fund?

A money market fund is a type of mutual fund, sponsored by an investment fund company (such as Charles Schwab, Fidelity, Vangurad, etc). It invests in high-quality, short term debt instruments, cash, and cash equivalents. Given their underlying investments, money market funds are designed to offer high liquidity with a very low level of risk.

Note: While similar in name, a money market fund is different than a money market account (which is an interest bearing savings account offered by a bank). This article will focus on money market funds.

Wait, is it cash then?

No. Money market funds are investment vehicles. You have to trade in and out of them just like any other investment security. Further, since they are investments, they do carry slightly more risk than cash itself. However, given the underlying investments and regulations (more on that below), the risk is extremely low. Further, since they are invested in items beyond cash, they usually offer higher interest rates than pure cash balances.

Are they always valued at $1?

Money market funds seek to maintain a constant net asset value (“NAV”) of $1. NAV is the measure of the per-share value for any mutual fund. Money market funds are subject to special pricing and valuation conventions, allowing them to maintain a constant NAV of $1. Any excess earnings that get generated through interest on the portfolio holdings are distributed to investors in the form of dividend payments. These payments can be taken in cash or used to reinvest in more shares.

Can they fall below $1?

As noted above, money markets typically retain a $1 NAV. Failure to do so (otherwise known as “breaking the buck”) is extremely rare. The most recent occurrence was in 2008 with a money market fund invested in Lehman Brothers debt. New regulations were put into place in response to this event, making the likelihood of such an event in the future even more rare – but not impossible

What are the different types of money market funds?

Money market funds are classified into various types, depending upon the underlying assets in the fund (their nature, maturity, and other factors). The common types are:

• Prime money fund – invested in floating-rate debt and commercial paper of non-Treasury assets, like those issued by corporations, U.S. government agencies, and government-sponsored enterprises

• Government money fund -invests at least 99.5% of its total assets in cash, government securities, and repurchase agreements that are fully collateralized by cash or government securities

• Treasury money fund – invests in standard U.S. Treasury-issued debt securities, such as Treasury bills, Treasury bonds, and Treasury note.

• Tax exempt money fund – invests primarily in municipal bonds so it can offer earnings that are free from U.S. federal income tax. Depending on the exact securities it invests in, a tax-exempt money fund may also have an exemption from state income taxes.

Are money market funds a good choice for me?

As always, this answer is “it depends.” Money market funds do offer high levels of liquidity, price stability, along with interest rates that currently exceed that available in cash/standard savings accounts. However, these instruments do not provide for any level of capital appreciation and are not FDIC insured as pure cash or a bank account may be.

As always, we suggest you consult with your own financial advisor in determining the role these investments can play in your portfolio.

Note: All commentary above is as of the date of this post and is for education and informational purposes only. Windermere and its principals do not intend for this to serve as investment advice and are not responsible for any actions taken based on this article. Consult your financial advisor before taking any actions as it relates to your own investment portfolio