Money Market Funds Can Add Stability and Liquidity

 

Key Points

» The Money Market
» High Quality, Low Market Risk
» Money Market Investments
» The Benefits of Money Market Funds
» 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

 

1. Money market funds are pools of short-term investments that
   usually mature within one year.
2. Money market funds seek to maintain a stable net asset value of
   $1, but this is not guaranteed.
3. The relative safety of money market funds must be balanced
   against the need for higher returns for long-term savings to
   outpace inflation.
4. 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.
5. 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.

¹Investment in a money market fund is neither insured
nor guaranteed by the U.S. government, and there can be no
guarantee that the fund will maintain a stable $1 share price. The
fund’s yield will vary.

²Keep 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.

³CDs 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.

© 2010 Standard & Poor’s Financial Communications. All
rights reserved.