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Money market funds explained

If you’re looking for investment options with the potential of good returns, you’re probably familiar with investment funds and ISAs. However, fewer people have heard of money market funds, which are an increasingly popular option for short-term investing. On this page, you’ll find out more about money market funds, how they work, the different types and some of the pros and cons, to help you decide if this type of investment might be suitable for you.

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The rundown
  • Money market funds are a type of mutual fund that invests in high-quality securities over the short term, potentially lowering your risk
  • Securities that a money market fund invests in usually mature in less than a year, so you’ll quickly see a return on your investment
  • Money market funds aren’t usually suitable for long-term investments because their rates are initially high, but almost always decrease over time

What is a money market fund?

A money market fund is a type of mutual fund that invests in high-quality securities with short-term maturity, such as stocks or bonds. This type of fund is relatively low risk and usually pays out your return in dividends, with other alternative payments also available. A money market fund is often sponsored by an investment fund company, which means it carries no guarantee of principal, meaning that you may not receive the amount you invested back. 

How do money market funds work?

By investing in short-term securities, the main goal of a money market fund is to reduce uncertainty and control risk, because in most funds, the longer you lend your money to a person, business or government, the greater the risk, such as not getting repaid. 

Money market funds are generally restricted to investing in what are considered low-risk securities, such as government bonds and commercial paper. These securities often reach maturity in under a year, at which point you’ll get your return. 

Why use a money market fund?

Investors mainly use money market funds because they are considered a low-risk investment, yet can still provide a good return. 

Investments you make in a money market fund are also liquid, meaning you typically access your money within a few business days, giving you quick and convenient access to cash. It typically takes a day for a sale in a money market fund to settle. Once it’s settled, you can then transfer your funds to an account that allows you to spend or withdraw.

Some money market funds provide the convenience of allowing you to write cheques to withdraw your money from the fund, giving you the advantage of earning dividends and the ability to access your money easily. However, it’s always best to check the provider’s restrictions and fees

Money market funds may pay high rates initially, but it’s important to be aware that they can decrease over time, and money market funds often have lower returns for long-term investments. If you want your rates to continue rising, you might want to consider keeping your money in an investment that adjusts to the market. They are a higher risk option, but you may see higher returns.

What are the different types of money market funds?

There are different types of money market funds, which depend on the invested asset, maturity period and other factors. The following are the most common types of money market funds:

  • Prime money fund – invests in floating-rate debt and commercial paper of non-treasury assets, such as those issued by corporations, government agencies and other enterprises sponsored by the government.
  • Government money fund – invests at least 99.5% of its total fund in cash, government securities and repurchase agreements.
  • Treasury fund – invests in U.S. treasury debt securities, such as treasury bills, bonds and notes.
  • Tax-exempt money fund – invests in short-term debt obligations issued by tax-exempt entities. They usually have a very low rate of interest but offer tax-free income.

Pros and cons of money market funds

Pros Cons
Money market funds can be lower risk compared to other mutual funds because the goal is to invest in short-term, liquid-based assets. Not suitable for long-term investment goals because they don’t offer a high capital appreciation.
Typically offer better returns than traditional bank accounts, with minimum risks involved in the investments. Money market funds can be very sensitive to interest rate fluctuations. If you’re looking to maintain a high interest rate, a money market fund may not be the best investment option for you.
Money market funds are suitable for active investors who can constantly look for short-term assets that offer the best possible rates. There is no protection for your investments, which means there’s a chance you can lose your money.

What should I consider when investing in money market funds?

Money market funds are typically suited to investors with short-term investment goals. However, earning a good return on a short-term investment is often difficult, making money market funds an increasingly popular option. They might also be suitable if you are more risk-averse, as your investment will be affected less by stock market volatility. 

Money market funds typically diversify their investments, which means there’s less risk of losing all your money if one company the fund has invested in fails, as more of your money is spread across investments in several companies. 

Risks of money market funds

Several risks come with money market funds. The main risk, as with any investment fund, is losing your investment. You could consider money market funds more secure, as fund managers attempt to keep the share price at £1. However, there’s no guarantee that the price will remain at £1, which means if the share price declines, you could lose the value of your initial investment. In the US, this is known as ‘breaking the buck’. 

Investments in money market funds are not secured. Unlike UK-regulated savings accounts, money market funds are not backed by the Financial Services Compensation Scheme (FSCS), which allows you to claim your money back if the financial institution your money is with fails. Without this protection, your money is at risk. 

Money market fund interest rates are variable, which means you don’t know what the return on your investment will be. While it’s beneficial if the interest rate increases, but if it goes down, you may end up losing the value of your investment

Another risk to consider is an increase in inflation, which can diminish your returns over time. Although money market funds are liquid, this doesn’t fully eliminate the risk of losing money and paying higher fees. If you need to withdraw your funds suddenly, you may have to pay a substantial amount just to cash out. 

Investing in money market funds vs opening a savings account

If you’re uncomfortable with the risks involved in investing in a money market fund, you might want to consider a safer investment. Opening a savings account, such as a fixed rate bond, allows you to earn a competitive interest rate that’s guaranteed, as long as your deposits are protected

The main benefits of choosing to save your money in a fixed rate bond are that you’re guaranteed a return on your investment, and, as long as the financial institution you save with is protected by the FSCS, your money will be safe. Saving into a fixed rate bond provides the peace of mind that your money is safe, and allows you to earn interest passively. 

If you want to quickly and easily open a fixed rate bond, register for a free Raisin UK Account and apply today. Opening savings accounts with competitive interest rates from a range of UK banks through our marketplace is free, and through your Raisin UK Account, you can manage multiple savings accounts in one place. 

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