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.

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The Pros and Cons of Money Market Funds (2024)

FAQs

The Pros and Cons of Money Market Funds? ›

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.

What are the pros and cons of money market funds? ›

Money market funds have benefits such as diversifying your investment portfolio and providing regular income payments. But your money won't be federally insured and you may incur fees.

What are the pros and cons of a fund? ›

Some of the advantages of mutual funds include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing, while disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution.

What are the advantages and limitations of money market? ›

While the money market offers high liquidity, low risk, competitive interest rates, and diversification, it also comes with relatively low returns and a lack of potential interest rates and credit risks on which investors can base their financial goals and risk tolerance.

What are the cons of money market instruments? ›

Cons. Although money market funds are typically regarded by most investors as relatively safe investments, it is possible to lose money by investing in such funds. They aren't FDIC insured, nor are they guaranteed by the U.S. government or a government agency.

Is it wise to invest in money market funds? ›

Money market funds don't have the long-term growth potential of stock or bond funds; however, they are considered a more stable investment and can be especially useful for immediate- to short-term savings goals that you don't want impacted by market volatility.

Is there any risk with 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.

What are the cons of money market mutual funds? ›

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.

What are the risks of money funds? ›

Because they invest in fixed income securities, money market funds and ultra-short duration funds are subject to three main risks: interest rate risk, liquidity risk and credit risk.

Which type of fund is best? ›

Equity mutual funds are the best option for long term investment. Based on your risk-taking capacity, investment can be made in other sub-categories within equity mutual funds, such as large cap funds, mid-cap funds, and small-cap funds.

Can a money market account lose money? ›

There is no direct way to lose money in a money market account. However, it is possible to lose money indirectly. For example, if the interest rate you receive on your account balance can no longer keep up with any penalty fees you may be assessed, the value of the account can fall below the initial deposit.

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

Currently, money market funds pay between 4.47% and 4.87% in interest. With that, you can earn between $447 to $487 in interest on $10,000 each year. Certificates of deposit (CDs). CDs are offered by financial institutions for set periods of time.

How much money should you keep in a money market account? ›

Some money market accounts come with minimum account balances to be able to earn the higher rate of interest. 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.

Are money market funds safe in a recession? ›

Money market funds can protect your assets during a recession, but only as a temporary fix and not for long-term growth. In times of economic uncertainty, money market funds offer liquidity for cash reserves that can help you build your portfolio.

How safe is a money market fund? ›

The Bottom Line. Both money market accounts and money market funds are relatively safe, low-risk investments, but MMAs are insured up to $250,000 per depositor by the FDIC and money market funds aren't.

What is the safest money market instrument? ›

Treasury Bills (T-Bills)

Treasury Bills, which are issued by the federal government, are among the safest money market securities available. Treasury bills, however, have no risk. i.e., are instruments with zero risk. As a result, the results one receives from them are not desirable.

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

However, money market funds are not suitable for long term investment goals, like retirement planning. This is because they don't offer much capital appreciation.

Are money market funds a good idea now? ›

Money market funds can be a good fit for investors looking to benefit from the current interest rate environment or saving for a short-term goal. Keep in mind that while the funds are considered low risk, they are not FDIC-insured.

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