You're probably familiar with the term "money market fund" -- but there's a good chance you have little to no idea what it really is. If so, it's time to change that, as there are times when a money market fund makes a great place to put your cash -- and times when there are better options.
Read on to learn what everyone should know about money market funds.
What it is
A money market fund is a mutual fund -- the pooled assets of many investors, invested in various securities. In the case of a money market mutual fund, the assets are invested in short-term, high-quality securities that are fairly low-risk and also highly liquid, i.e., easily converted into cash. For example, it's likely to contain government securities, tax-exempt municipal securities, certificates of deposit, and/or corporate debt securities.
Investments in money market funds are not likely to make you wealthy, but they can keep your money relatively safe while providing a modest amount of interest. Whatever interest is paid to the fund company by the underlying securities is passed along to shareholders. Of course, with interest rates currently so low, money market funds are not great income-generators these days.
Note that while typical mutual funds have net asset values (NAVs) that fluctuate along with the value of their underlying stocks, bonds, or other securities, money market funds are designed to have stable NAVs of $1. When such a fund is serving you well, its value will remain at $1 per share, but you'll receive interest payments regularly -- which can be reinvested in additional shares.
There are different kinds of money market funds, too, with some specializing in municipal debt and offering tax-exempt income (though these often sport lower interest rates than taxable money market funds).
Downsides of a money market fund
Money market funds aren't all roses, though. Modest interest payments might sound fine, but remember that inflation averages about 3% annually over long periods, so if you're earning 1% or 2% from a money market fund, you're likely losing purchasing power.
Money market funds charge fees, too, which can make a significant dent in your overall return. Be sure to learn about all fees before investing in any fund.
While money market funds may seem like they're mostly the same, they're not. They invest in generally low-risk securities, but some of those will perform better than others, which in turn lead certain funds to outperform their peers.
Finally, money market funds aren't insured by the Federal Deposit Insurance Corporation, unlike most deposits at banks. There have been rare instances throughout history when money market funds were unable to pay back shareholders at the expected $1 per share, causing those investors to lose money.
To prevent this from happening, the Securities and Exchange Commission amended its rules for money market funds in 2010, aiming for reductions in their portfolios' interest rate, credit, and liquidity risks. In 2014, the SEC voted in favor of additional rules to strengthen the funds. For example, institutional money market funds (often found in 401(k)s) are required to have floating NAVs instead of the fixed $1 NAV that retail money markets have. The SEC also voted to limit money market fund investors' ability to cash in shares when the market is in turmoil -- and even to charge them extra fees for doing so. The redemption changes have been somewhat controversial,as they seem to go against the concept of the money market fund as a safe place to park money that can be easily withdrawn. Nevertheless, these changes go into effect in the fall of 2016.
What it isn't: a money market account
A money market fund is distinct from a money market account, which is sometimes referred to as a money market deposit account. While money market funds are mutual funds, money market accounts are deposit accounts offered by banking institutions -- and they do offer FDIC protection. They also invest in low-risk, high-quality securities, aiming to offer investors stability and a little income.
Money market accounts often pay interest rates that are slightly lower than what money market funds pay but slightly higher than savings account rates. Some money market accounts will offer you limited check-writing privileges, too.
Money market investments can be good choices for your short-term cash, such as money you've saved for a down payment or tuition payment that you expect to make in the near future, or an emergency fund. Don't put long-term cash into them, though, because they're not designed to be wealth growers. They won't build you a more comfortable retirement, and they may even lose purchasing power over time.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.