What they are
Money market mutual funds are similar to money market accounts, but money market funds are not insured by the Federal Deposit Insurance Corp. They tend to be a little riskier than their bank counterparts, and that is reflected in the rate.
Money market funds nearly always maintain a $1 per share net asset value, but that rule has sometimes been broken. Following the collapse of Lehman Brothers in 2008, the share price of one money market fund dipped below $1. To avoid breaking the buck, 62 others had to be propped up by their parent companies, according to a report from Moody's in 2010.
How they work
Money market funds hold high-quality, short-term debt securities such as Treasury bills. They're required to hold a certain amount of cash or cash equivalents in order to maintain a certain level of liquidity.
But not all money market mutual funds are the same. Some invest in municipal bonds and offer a little yield exempt from federal income tax, while others yield virtually nothing -- at least these days -- but do provide a safe place to hold money. Examples of the types of investments money market funds hold are Treasuries, certificates of deposit, commercial paper and debt securities issued by foreign banks.
Advantages and disadvantages
In a more normal interest rate environment, money market funds may offer yields that are comparable to less liquid investments such as CDs.
Though money market funds offer better liquidity, they could potentially lose money, though the likelihood is remote. According to the Investment Company Institute, the mutual fund industry trade association, four factors could cause a deviation from the $1 net asset value.
- Changes in interest rates.
- The maturity of the fund's portfolio.
- Lots of money flowing in and out.
- Credit events affecting securities held in the fund.
Many money market funds invest in foreign bank obligations, and many European banks hold sovereign debt from the imperiled Portugal, Italy, Ireland, Greece and Spain -- notably Greece. A Greek default on sovereign debt could potentially spiral down to American money market funds, but domestic money market funds have been reducing their exposure to European banks in recent months.
In October, Fitch Ratings reported European bank holdings account for 37.7 percent of the 10 largest U.S. prime money market funds.
Though the possibility of losing money in a money market fund exists, a more salient concern is the erosion of purchasing power by inflation.
"There is about $2.6 trillion in money market funds that's actually losing money every single year in terms of its inflation-adjusted purchasing power, which is the object of keeping money in bonds," says Larkin. "So people are putting up red ink every year, but they don't see it. They feel good, but the price doesn't move. And that is a huge trap."