The Pros and Cons of Money Market Funds (2024)

What Are Money Market Funds?

Money market funds are a type of mutual fund that invests in highly-rated, short-term debt securities. They generate income but little if any capital appreciation. Money market funds were established in the 1970s to provide a slightly higher-yielding alternative to interest-bearing bank accounts.

Money market investing typically carries a low single-digit return. When compared to stocks or corporate debt issues, the risk to principal is generally quite low. However, investors need to weigh several pros and cons when it comes to money market funds.

Key Takeaways

  • Money market investing can be advantageous if you need a relatively safe place to park cash in the short term or if you're diversifying a growth portfolio.
  • Some disadvantages are low returns, a loss of purchasing power, and the lack of FDIC insurance.
  • A money market fund can be ideal in some situations and potentially unwise in others.
  • If you're close to or in retirement and need some of your money soon, a money market fund can make sense.

Advantages of Money Market Funds

Low Risk and Short Duration

When the stock market is extremely volatile, and investors aren't sure where to invest their money, the money market can be a safe haven for it while they decide where to put it to use. Why? As stated above, money market funds are often considered less risky than their stock and bond counterparts.

That's because these types of funds typically invest in low-risk vehicles such as certificates of deposit (CDs), Treasury bills (T-Bills), and short-term commercial paper.

Plus, the short durations of these securities limit a money market fund's sensitivity to interest rate risk.

And even though the money market often generates a low single-digit return for investors, in a volatile or down market, that can be quite attractive.

Diversification

As with most mutual funds, a money market fund offers instant diversification among a range of securities. Investors don't have to select and invest in various money market securities individually. Diversification is an important safeguard for every portfolio.

Stability and Security

A money market fund is one of the least volatile types of investment available. This characteristic can be useful in offsetting the greater volatility of stock and bond investments you may have in your portfolio. In addition, they give you a secure, short-term investment option when no other is feasible.

A money market account is an interest-paying account opened at a bank. A money market fund is a mutual fund.

High Liquidity

Money market funds generally don't invest in securities that trade minuscule volumes or have little following. Rather, they primarily invest in entities and/or securities in fairly high demand (such as T-bills and short-term T-bonds). This meansthey tend to be very liquid; investors can buyand sell them with comparative ease.

Contrast this to, say, shares of a small-cap Chinesebiotech company. In some cases, those shares may have limited investor interest. This means that getting into and out of such an investment could be difficult if the market were in a tailspin.

Potential Tax Efficiency

Investors in money market funds may find that the interest payments from some fund investments are exempt from federal and, potentially, state income taxes.

Disadvantages of Money Market Funds

Inflation Risk

If an investor is generating a 3% return from their money market fund, but the rate of inflation is humming along at 4%, they are essentially losing purchasing power each year.

Expenses Can Take a Toll

When investors are earning only 2% or 3% from a money market fund, even small annual fees can eat up a substantial chunk of the profit. This may make it even more difficult for money market investors to keep pace with inflation.

Depending on the fund, fees can vary in their negative impact on returns. If, for example, an individual maintains $5,000 in a money market fund that yields 3% annually and is charged $30 in fees, the total return can be impacted quite dramatically.

  • $5,000 x 3% = $150 total yield
  • $150 - $30 in fees = $120 profit

The $30 in fees represents 20% of the total yield, a large deduction that considerably reduces the final profit. The above amount also does not factor in any tax liabilities that may be generated if the transaction occurs outside of a retirement account.

No Federal Insurance Protection

A money market account opened at a bank is typically insured by the Federal Deposit Insurance Corporation (FDIC) for up to $250,000 per depositor. However, money market funds are not insured by the FDIC—but the Securities Investor Protection Corporation (SIPC) provides some degree of financial protection for investors.

For instance, if an investor were to maintain a $20,000 money market account with a bank and the bank were to go belly up, the investor would likely be made whole again through this FDIC coverage. On the other hand, if a money market fund were to collapse, the investor could lose some or all of their money because the SIPC only replaces the investments when possible.

The 2008 financial crisis took a lot of the shine off the stellar reputation that money market funds had enjoyed. A large money market fund broke the buck—its shares fell below $1.00—triggering a run on the whole money market industry. Since then, the industry has worked with the Securities and Exchange Commission (SEC) to introduce stress tests and other measures to increase resiliency and repair some of the reputational damage.

Risk of Higher Yields

While money market funds generally invest in government securities and other vehicles that are considered safe relative to investments such as stocks and bonds, fund managers may decide to take some greater risks to obtain higher yields for their investors.

For example,to try to capture another tenth of a percentage point of return, the fundmay invest in bonds or commercial paper that carry additional risk. Depending on your investment objectives and time horizon, investing in the highest-yielding money market fund may not always be the smartest move, given this additional risk.

Remember, the return a fund has posted in a previous year is not necessarily an indication of what it may generate in a future year.

Low Returns Mean Lost Opportunity

Over time, common stocks have returned about 8% to 10% on average (including data from recessionary periods). By investing in a money market fund, which may often yield just 2% or 3% due to the fixed income nature of its investments, an investor may be missing out on an opportunity for a better rate of return. This can have a tremendous impact on an individual's ability to build wealth over time.

What Is In a Money Market Fund?

A money market fund is a type of mutual fund that invests in highly liquid, low risk short-term securities. As such, you'll typically find short-term Treasuries, other government securities, CDs, and commercial paper listed as holdings.

Is a Money Market Account the Same As a Money Market Fund?

No. A money market account is an interest-bearing account that's offered by a financial institution such as a bank (as an alternative to a potentially lower-paying savings account). A money market fund is an investment sponsored by a mutual fund company.

Does the U.S. Government Provide Insurance for Money Market Funds?

No, it doesn't. Nor does it do so for any other type of mutual fund. Money market funds are investments with no guarantee of a return or principal protection. You can lose money with a money market fund investment.

The Bottom Line

As with any other investment, money market funds have pros and cons, which should be considered carefully before buying.

While money market funds aren't ideal for long-term investing due to their low returns and lack of capital appreciation, they offer a stable, secure investment option for individuals looking to invest for the short term.

The comments, opinions, and analyses expressed on Investopedia are for informational purposes online. Read our warranty and liability disclaimerfor more info.

The Pros and Cons of Money Market Funds (2024)

FAQs

The Pros and Cons of Money Market Funds? ›

If the interest rates on money market instruments fail to keep pace with inflation, the real value of the investment can erode over time. This can impact the purchasing power of the investor's funds. Limited Growth Potential: Money market investments may not provide significant opportunities for capital growth.

What are the disadvantages of the money market? ›

If the interest rates on money market instruments fail to keep pace with inflation, the real value of the investment can erode over time. This can impact the purchasing power of the investor's funds. Limited Growth Potential: Money market investments may not provide significant opportunities for capital growth.

Why would you not invest in a money market fund? ›

While money market funds aren't ideal for long-term investing due to their low returns and lack of capital appreciation, they offer a stable, secure investment option for individuals looking to invest for the short term.

What are the risks of a money market account? ›

The biggest risk a money market account poses is that your money may lose value over time to inflation. Depending on inflation and the interest rate you earn with your money market account, inflation may outpace your MMA's earnings.

Are money market funds safe in a recession? ›

Money Market Funds

Ultra-conservative investors and unsophisticated investors often stash their cash in money market funds. While these funds provide a high degree of safety, they should only be used for short-term investment. There's no need to avoid equity funds when the economy is slowing.

How much will $10,000 make in a money market account? ›

The average money market rate is less than 1 percent. But let's say you put $10,000 in an account that earns a full 1% APY. After a year, your balance would earn 100 bucks. Put that same amount in a money market account with a 4% APY, and it would gain just over $400.

How long should I keep money in a money market fund? ›

Six to 12 months of living expenses are typically recommended for the amount of money that should be kept in cash in these types of accounts for unforeseen emergencies and life events. Beyond that, the money is essentially sitting and losing its value.

Has anyone ever lost money in a money market fund? ›

If the interest earned is low enough and the fees for the account are high enough, you may lose money. Although money market accounts aren't subject to the ups and downs of the stock market, they may come with higher fees than other savings products.

What is better than a money market fund? ›

Alternatives to money market funds, money market accounts, and savings accounts include: Certificates of deposit: CDs are term-based savings accounts that lock up your funds for a set time period in exchange for higher interest rates.

Should I put all my money in a money market fund? ›

Money market funds are ideal for short-term saving because they invest in highly liquid securities with the objective of capital preservation and income. Money market fund yields have risen above 5%, benefiting from the Federal Reserve raising interest rates over the last couple years.

What is the safest type of money market fund? ›

Vanguard Treasury Money Market Fund

This fund only invests in US Treasuries and repurchase agreements insured by the federal government, making it among the safest in a category of relatively safe investments. The weighted average maturity of the fund's holdings is 43 days.

Who typically uses a money market account? ›

For the most part, money markets provide those with funds—banks, money managers, and retail investors—a means for safe, liquid, short-term investments, and they offer borrowers—banks, broker-dealers, hedge funds, and nonfinancial corporations—access to low-cost funds.

Are money markets safer than bank accounts? ›

Money market accounts and savings accounts are equally safe places for consumers to keep their savings. However, it's important to open accounts at banks that are covered by FDIC insurance. You can check if your bank is FDIC-insured here.

Where is the safest place to put money if banks collapse? ›

1. Federal Bonds. The U.S. Treasury and Federal Reserve (Fed) would be more than happy to take your funds and issue you securities in return. A U.S. government bond still qualifies in most textbooks as a risk-free security.

Where is my money safest during a recession? ›

Cash equivalents include short-term, highly liquid assets with minimal risk, such as Treasury bills, money market funds and certificates of deposit. Money market funds and high-yield savings are also places to salt away cash in a downturn.

How many times have money market funds broke the buck? ›

How much should a money market investor be concerned with that risk? Smith: Since their introduction in 1971, money market funds have broken the buck just two times. The first was in 1994, when a fund was liquidated at 96 cents per share because of large losses in derivatives.

What are the 5 disadvantages of money? ›

The following are the various disadvantages of money:
  • Demonetization - ...
  • Exchange Rate Instability - ...
  • Monetary Mismanagement - ...
  • Excess Issuance - ...
  • Restricted Acceptability (Limited Acceptance) - ...
  • Inconvenience of Small Denominators - ...
  • Troubling Balance of Payments - ...
  • Short Life -

What are 5 disadvantages of a market economy? ›

Disadvantages of a market economy include inequality, negative externalities, limited government intervention, uncertainty and instability, and lack of public goods.

Are there fees with money market accounts? ›

You can use these to make unlimited withdrawals at ATMs without worrying about federal limitations. And the best money market accounts have no monthly fees, minimum balance requirements or a minimum opening deposit.

What is better, a high yield savings account or a money market account? ›

You can sometimes find higher rates with high-yield savings accounts than with money market accounts. However, many money market accounts offer tiered rates, so if you have a larger amount of money to deposit, you may end up earning more interest with a money market account than with a high-yield savings account.

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