With the rise in interest rates over the past year and change money market funds have become an increasingly popular place to store cash. The thing that most folks don't understand is these funds are very different than cash held at the bank in a bank money market account. Today we'll talk about money market funds and how they differ from money market accounts at the bank. It's a topic that's been on my mind lately, especially with all the money flowing into these funds.
First things first, as I said - a money market fund is not the same thing as a money market account at the bank. Money market funds are a type of mutual fund and are not FDIC insured. That means they are not bank accounts and are subject to potential loss just like other investments.
Exactly how does a money market fund work?
So let's talk about exactly what a money market fund is and how it works. There are different versions of these funds, but none of them are FDIC insured. They are investments and not bank accounts. They look similar to cash in the bank because they have a steady net asset value (NAV) of $1. This means that if you have $200,000 in a money market fund, it will look like $200,000 in a bank account. Technically what you have are 200,000 shares of the mutual fund. They are not required to price the NAV based on the underlying investments in the fund as long as they maintain a certain portion of the fund in investments that mature daily, weekly, etc.
However, in times of financial turmoil, the NAV of a money market fund may not actually be worth a dollar. This is where the risk comes in. If the fund breaks the buck, meaning the fund company is required to restate the NAV at it's actual value, which may be less than $1, investors may lose money. This is a very rare occurrence, but it has happened before. This happened in 2008 with the Reserve Primary Fund. It was a fund that invested in asset-backed securities, and commercial paper. Commercial paper is short term, typically overnight loans made to companies. In the case of the Reserve Primary Fund they had lent a fair amount of money to financial firms, which as we know in 2008 experiences a liquidity crisis.
As the happened they were unable to pay off their commercial paper, and so the holders of those investments (including the Reserve Primary Fund) experienced losses. This caused them to "break the buck" meaning that those holding the fund experienced losses.
What types of money markets exist?
There are generally three types of money market funds: government funds, treasury funds, and prime funds. Government funds invest in short-term securities that are backed by the US government. As of this typing the US has never defaulted on it's debt, so to this point goverment funds have not experienced the same issues described above, even in times of distress. Similarly, Treasury funds can only invest in US treasuries, which are a specific type of government debt.
Prime funds, on the other hand, can invest in assets outside of just government securities. They can invest in a wider range of securities, including corporate debt, commerical paper, asset backed securities, etc. In comparison to the prior two types this means they have a higher level of risk.
So, what should you consider when looking for a place to park your cash? First, make sure you understand the risks involved with money market funds. If you're not comfortable with the risk, stick to FDIC-insured bank accounts. Second, do your research and understand the different types of money market funds available. Consider investing in a government or treasury fund if you want to minimize risk.
In conclusion, money market funds are not the same thing as money market accounts at the bank. They are investments and are not FDIC insured. If you're considering investing in a money market fund, do your research and understand the risks involved.