What is a money market fund?
A money market fund is a mutual fund that invests in high-quality, short-term securities. Money market funds typical hold income-producing investments issued by big corporations and the U.S. Government, among others. These kinds of securities normally don’t fluctuate much in value. This helps the share price of money market funds to remain pretty stable. That’s why some investors consider them “cash equivalents.”
What is a Cash Equivalent?
Cash equivalents are a distinct asset class. And while cash may refer to the bills in your pocket, it is also a term used to loosely define various short-term investments. Some consider money in a bank account as cash. Investments in money market funds are also referred to as cash equivalents.
Money market funds may offer attractive interest rates relative to interest-bearing accounts[i]. This may be why many investors include them as part of the cash equivalent component of their long-term asset allocations. There is about $4.6 trillion invested in them.[ii]
Investment Features of Money Market Funds
There are a couple reasons why investors might use money market funds as part of their asset allocation strategies. The first is safety.
Since 1980, there have been only two money market funds unable to maintain a stable $1.00 Net Asset Value (NAV).[iii] This type of relative safety may make them appropriate for an investor seeking to diversify a portfolio that would otherwise contain just stocks and bonds.
The second investment feature money market funds offer is liquidity (the ability to quickly and easily convert the investment into cash). Proceeds from the sale of money market shares are generally available the same day to acquire other investment securities and can generally be withdrawn from an investment account the next regular business day.
This liquidity may make money market funds appropriate to finance a couple of financial goals. They can be used to temporarily keep capital on the sidelines – for when an opportunity arises. And they can be used to build and maintain an emergency fund.
Money Market Funds and Rising Interest Rates
It can be challenging for fixed income investments to generate attractive cash flows when interest rates are low. This may tempt some investors to seek higher yielding investments.
But replacing cash equivalents with higher yielding asset classes may come with consequences. This is especially the case if interest rates begin to rise.
For example, replacing a money market fund with a short term bond fund – because it provides more income – could actually deliver a negative total return.
This is because bond values generally decline as interest rates rise. Money market funds may behave differently. The short-term investments they hold are not likely to lose value as interest rates go up. But if rates do rise, then the income generated by a money market fund may also increase.
Cash Equivalents and Reducing Risk
Modern Portfolio Theory justifies the inclusion of cash equivalents in many asset allocation models because it helps reduce a portfolio’s overall risk profile.
Reducing risk is why some investors seek to increase their allocation to cash equivalents in volatile market environments. But reducing risk may also decrease a portfolio’s long-term return.
If you have questions about money market funds, our Representatives are available at (800) 235-8396.
