Money market funds can add stability & liquidity
Key Points
- The Money Market
- High Quality, Low Market Risk
- Money Market Investments
- The Benefits of Money Market Funds
- How Money Market Funds Seek to Maintain a Stable Net Asset Value
- How a Money Market Fund Fits in Your Portfolio
- Stability vs. Growth
- Traditions May Change
- Points to remember
When you begin to build a portfolio of investments, you need to consider your short-term goals as well as your long-term goals. For example, do you plan to take a vacation or buy a car during the next year? You must also think about what portion of your portfolio will need to be liquid, or easily accessible, in case of emergencies. In addition, consider how much stability your portfolio will need to allow you to feel comfortable as you pursue your longer-term goals.
Offering higher rates of return than traditional bank deposit accounts (albeit without the federal insurance), money market mutual funds can serve short-term and emergency cash needs, as well as provide an element of stability to help diversify your portfolio.1
The Money Market
Some investors believe that money market mutual funds invest in stocks. In fact, they do not. Money market funds invest in short-term debt instruments purchased on what's known as the "money market."
The money market is not a particular place, but rather how the U.S. government, banks, corporations, and other large institutions manage their short-term cash needs. For example, when the U.S. government needs money quickly, it borrows from the money market by issuing Treasury bills (T-bills) that institutions and extremely wealthy individuals will purchase. The T-bills represent the government's promise to pay back the loan.2 These investments mature, or come due, in short periods of time, when the government repays the loan.
Similarly, banks will offer short-term debt instruments called certificates of deposit (CDs), and corporations will offer commercial paper3. Other securities traded on the money market include repurchase agreements, banker's acceptances, and government-agency obligations. Money market investments also include short-term tax-exempt issues from municipalities and maturing municipal bonds.
High Quality, Low Market Risk
Money market investments generally have a high credit quality, which means that there is little risk that their issuers will not be able to repay their debt. Because of this high quality, they are considered low-risk investments. Money market mutual funds pool these securities in one investment vehicle that brings low-risk opportunities to the everyday investor.
In addition, the securities held within a money market fund have short maturities, usually one year or less. These short maturities result in a low sensitivity to interest rates. In other words, as long as the fund can hold its securities to maturity, the value of the fund will not fluctuate due to changes in interest rates.
Because of their low-risk holdings and their low susceptibility to changes in interest rates, money market mutual funds are able to offer shares at the net asset value of $1 and can strive to maintain this stable value, assuring investors of little risk to their principal.1
Money Market Investments
- Commercial Paper
- Treasury Bills
- Banker's Acceptances
- Repurchase Agreements
- Certificates of Deposit
The Benefits of Money Market Funds
In addition to providing stability and low risk, money market funds offer the following benefits:
- Liquidity — Money markets do not require you to invest your money for set amounts of time. You can access your money whenever you need it, without penalty. Other short-term, stable investments are not as liquid. For example, CDs charge penalties for early withdrawals, and cashing in bonds early could cause you to lose twofold: (1) you forgo any future income on the bond if you do not reinvest your money and (2) if the price of your bond has dropped since your original purchase, you lose money there, too.
- Very low fees — Because fund management is not as complex as it can be for other types of mutual funds, these funds can charge lower fees and expenses.
- Daily valuation — Dividends are credited to your account daily, which ensures that your earnings are always up to date and available.
- Lower minimum investments — Money market mutual funds generally offer lower initial investment minimums than other investments.
- Check writing — Many money market funds allow you to write checks against the balance, although there can be limits on this privilege.
- Competitive interest rates — During a high-interest-rate environment, money market mutual funds can offer competitive yields providing returns higher than bank savings and money market accounts.
How Money Market Funds Seek to Maintain a Stable Net Asset Value
Money market funds strive to maintain a reputation for safety by keeping the value of each fund share constant at $1. To achieve this, money market fund portfolio managers plan to hold each security they purchase until maturity, when the full principal is repaid by the issuer. If a portfolio manager has to sell a security before it matures, he or she runs the risk that it will have declined in value, either due to a general increase in interest rates or a decline in the credit quality of the issuer.
While portfolio managers can control many factors, one thing they cannot control is fund redemptions. A sharp rise in interest rates could cause fund redemptions to surge — requiring the fund manager to sell fund investments prior to their maturity, possibly "breaking the buck" (if the per-share value of the fund drops below $1).
How a Money Market Fund Fits in Your Portfolio
Within an investor's portfolio, money market funds can serve two main purposes: short-term cash needs and diversification.
- Short-term cash needs: You can redeem shares of your money market funds for short-term savings and cash needs. Examples include larger-ticket expenses you will have over the next year, such as that new car or vacation. Also, retirees often find money market funds to be appropriate vehicles for managing current income and cash needs, and for cash needs one to three years distant. Higher income earners may want to consider tax-exempt money market funds.
- Diversification: Money market funds can help bring stability to a portfolio heavily weighted in the riskier stock and bond investments. They can also serve as a convenient place to park substantial amounts of cash while you decide where you want to invest it.
Stability vs. Growth
While money market funds help short-term needs and diversification strategies, investors should remember that they are, certainly, conservative investments. Investing your portfolio too heavily in money market funds can hurt its potential for long-term growth. Investors who are primarily seeking high long-term returns may be best served by investing the majority of their money in bond and stock investments and a minority of emergency cash in money market funds. Because money market returns tend to just keep pace with inflation before taking taxes into account, money set aside in money market mutual funds can actually lose purchasing power after income taxes on annual returns are factored in.
Also, investors need to evaluate the short-term interest-rate environment before they choose money market funds. While such funds respond quickly and positively to rising short-term rates, the same holds true for rate declines. In a low-interest-rate environment, investors will need to shop around to find the best returns for their short-term needs.
Traditions May Change
Historically, most people have turned to their community bank for their short-term savings and cash-management needs. As the benefits of money market mutual funds become more widely known, that tradition may change, exposing more people to the stability and liquidity benefits of these funds. Talk to your financial advisor about whether money market funds have a place in your portfolio.
Points to Remember
- Money market funds are pools of short-term investments that usually mature within one year.
- Money market funds seek to maintain a stable net asset value of $1, but this is not guaranteed.
- The relative safety of money market funds must be balanced against the need for higher returns for long-term savings to outpace inflation.
- Money market funds can be excellent investments for short-term goals such as current cash needs, an upcoming vacation, or for retirees who may want to set aside several years' worth of annual living expenses.
- Individuals in higher income tax brackets may prefer tax-exempt money market funds, which invest in tax-exempt municipal bonds nearing maturity and short-term municipal issues.
1 An investment in a Money Market Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund.
2 Keep in mind that U.S. Treasury bills/U.S. government bonds are guaranteed as to principal and interest payments (although the funds that invest in them are not). However, the returns of U.S. Treasury bills/U.S. government bonds historically have not outpaced inflation by as great a margin as stocks, although past performance cannot guarantee future results.
3Bank CDs offer a guaranteed rate of return, guaranteed principal and interest, and are generally insured by the Federal Deposit Insurance Corp. (FDIC), but do not necessarily protect against the rising cost of living. While a money market fund aims to maintain a stable $1 share price, there can be no guarantee that the fund will achieve this objective, and its yield will vary.
Diversification helps you spread risk throughout your portfolio, so that investments that do poorly may be balanced by others that do relatively better. Diversification does not ensure a profit or protect against loss.
Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.
You should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. For a free prospectus, which contains this and other important information about the funds, contact your financial advisor or visit ameriprise.com. Read the prospectus carefully before investing.
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