Money Market Mutual Funds
By Investopedia Staff

If investing a large portion of your retirement fund in the stock market or equity fund makes you break into a cold sweat, you may be interested in investing in a money market mutual fund. What Is a Money Market Fund? In short, it is a mutual fund that invests solely in money market instruments. Just like a mutual fund, it issues redeemable units to investors and must follow guidelines set out by the SEC. A money market fund's net asset value (NAV) is also determined at the end of each day. Money market funds, however, are completely different from money market accounts and money market instruments. Money market accounts are basically special kinds of savings accounts that you can open at any local bank, and a money market instrument is a form of highly-liquid short-term debt security. Furthermore, unlike a bank account, returns from money market funds are not guaranteed even though they are lower risk. Their stability rests solely upon the investments that make up their portfolios and it is possible for the fund to lose money, although the odds of this occurring are rare. What's So Special About These Products? Money market funds are special for three reasons: Safety – The instruments that these funds invest in are by and large some of the most stable and safe investments. Money-market instruments provide a fixed return with short maturity. By purchasing debt securities issued by banks, large corporations, and the government, money market funds carry a relatively low default risk while still offering high returns in comparison to similar low-risk/liquid products. Low Initial Investment – Money market instruments generally have large minimum purchase requirements, thereby disqualifying the majority of personal investors from buying them. Money market funds, on the other hand, have substantially lower requirements, which are sometimes even lower than average mutual fund minimum requirements. Without necessarily requiring copious amounts of cash for their purchases, money market funds allow you to take advantage of the safety related to money market instruments. Fixed Net Asset Value – The NAV for money market funds is usually fixed at a constant value of $1 per unit, giving investors more flexibility than most mutual funds, which have a transaction-day-plus-three (T+3) settlement. Money market funds offer investors a same-day settlement similar to regular money market instruments. Specific Types of Money Market Funds: Taxable vs. Tax-free Money market funds are divided into two categories: taxable and tax-free. If you're buying a taxable fund, any returns from the fund are generally subject to the regular local, state, and federal taxes. Taxable funds mainly invest in U.S. treasury securities, government agency securities, repurchase agreements, CDs, commercial paper, and bankers' acceptances. Many other varieties of different investments are eligible for taxable money market funds. For instance, if you are partial to the housing sector, you can buy a money market fund that solely invests in Fannie Maes. Tax-free funds, on the other hand, do not come in such wide varieties. These funds invest in the short-term debt obligations issued by federally tax-exempt entities and are usually lower yield. In some areas, you can purchase tax-free funds that exempt you also from state and local taxes; however, these kinds of exemptions are exceptions rather than the norm, so be sure to check out all the details before you decide to purchase one. Weighing the Costs of Taxes and Lower Returns If you are deciding between tax and tax-free funds, it is important to calculate whether the tax savings created by the tax-free fund will be enough to make its lower yield worthwhile. Taxable funds generally have higher returns, but, if the tax on those returns is greater than the additional return you receive in comparison to its tax-free counterpart, the more optimal choice for an investor is to purchase the tax-free fund. Keep in mind that you can't just compare the two yields by themselves--what you need to do is convert the tax-free yield into an equivalent taxable yield. This can be accomplished with the following formula: Taxable equivalent yield = tax-free yield / (1 – your marginal tax rate) Let's say that you are in the 28% tax bracket and need to choose between the taxable money market fund with a yield of 1.5% and a tax-free fund with a yield of 1.2%. By converting the tax-free yield into a taxable equivalent yield (using the formula above) we get 1.67%, so the choice is obvious: the tax-free money market is the way to go since the tax savings offer us a better yield. As you move into higher tax brackets, the better the taxable equivalent yield becomes. When to Be Cautious Before you jump in to buy a money market fund, you should be aware of a couple of things. Management Expense Ratio - As with regular mutual funds, money market funds also have management expense ratios. Fund managers and companies need to be paid for their work, and they take their pay out of the return from the fund. A money market fund is never risk-free - Make sure you read the prospectus of the fund before you purchase it to make sure that you are investing in securities that are compatible with your risk profile. Whether you decide to use money market funds as an investment vehicle or as a temporary place to stash money while waiting for the right security to buy, make sure you know as much as possible about the fund and make certain it's the best one for you.

By Investopedia Staff