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Retail Money Market Funds
Retail Money Market Funds

Money Fund Basics

What Is a Money Fund?

Before the introduction of money funds, an entire world of investments existed that was not available to the individual investor. Only investors with $100,000 or more could afford to purchase high-yielding money-market debt instruments such as market-rate certificates of deposit (CDs) and commercial paper. These investments offered higher yields than other investment choices, but it wasn't until 1971 that the first money fund—The Reserve Fund—was established, enabling the small investor to invest in these instruments. Today, more than 1,800 money funds are in operation, with total assets of more than $2 trillion.

Money funds are mutual funds that invest in short-term debt instruments. They provide the benefit of pooled investments, as investors can participate in a more diverse and high-quality portfolio than they otherwise could individually. And like other mutual funds, each investor who invests in a money fund is a shareholder of the investment pool. Since money funds value the price of their individual shares at a constant price of $1.00, 1,000 shares of a money fund are a $1,000 investment, and the dividends on those shares are the return—or yield—on that investment. Prior to money funds, no mutual fund had a constant price per share, same-day liquidity or check-writing privileges.

There are two fundamental types of money funds: taxable and tax-free. Taxable fund yields are closely related to short-term interest rates in the U.S. financial and money markets. Tax-free fund returns, though, are based on the supply and demand of government, state and municipal short-term debt obligations, which provide tax-exempt interest to shareholders.

Why invest in a money fund?

Money funds offer safety and liquidity, both from their investments and their organization. Money-market instruments, by definition, are short-term (generally they mature in less than a year) and have an active secondary market in which they can be resold. Money funds are registered with the Securities and Exchange Commission (SEC) and, while they are not insured under any type of federal program, they are highly regulated by the SEC. Even though there were a number of money fund problems in 1994, no individual investor has ever lost money in a modern money-market fund. (see Safety section). Finally, money funds can provide liquidity in the most basic sense—most offer check writing and free, immediate share redemption by mail or by telephone, with money wired directly to your bank account.

Most investors who put cash in money funds use them as part of their overall investment strategy or as a savings account alternative. For example, some people liken money funds to a higher-yielding substitute for savings accounts offered at banks and thrifts. In fact, money funds almost always provide better returns than money-market deposit accounts. In recent years, money funds have outyielded popular bank money-market accounts, and often beat six- and 12-month CDs as well.

Often, money funds are used as a temporary "parking place" for cash. If the stock market looks unstable to you, for example, you may want to sell some of your stock fund shares and invest that cash in a money-market fund while you watch the stock market. Other people always keep some cash in money funds because they know the principal is safe and they can withdraw their money at any time. Then they may place the bulk of their investment money in other types of mutual funds for long-term growth.

Finally, investing in money funds makes good sense simply because of the yields they can earn, compared to other alternative investments. When short-term interest rates are rising, investing in money funds will normally be a better bet than stock or bond fund investments. Since money funds invest in short-term instruments, their fund managers can capture new, higher rates as soon as they are available.

Taxable Money Funds

With taxable money funds, any return on your investment is subject to federal, state and local income taxes in most cases. The yields are higher than those of tax-free funds because of the kinds of instruments in which taxable funds can invest.

In general, taxable money funds are divided into the following categories:

  • Retail money funds are open to any investor. Funds can be contacted directly for shareholder information, such as a prospectus and application or investors may use a stockbroker to purchase shares of stockbroker-affiliated funds.
  • Institutional money funds are designed primarily for institutional investors (bank trust departments, corporations, pension plans and the like), although individuals may sometimes invest through an institution, such as a bank trust department or a brokerage firm. Minimum initial investments are usually higher than retail funds, and the majority do not offer check writing.

Institutional money funds, in general, charge lower fees, so these funds often have higher net returns than the retail funds.

Fund holdings count

Taxable funds also are categorized by the instruments that they hold. Government money funds invest only in U.S. Treasury and/or U.S. government agency obligations, such as Freddie Macs or Ginnie Maes. Because these conservative funds hold only extremely safe instruments in their portfolios, their yields usually are lower than those of the broadly based funds, which may invest in a broader spectrum of money-market securities including prime commercial paper and Eurodollar certificates of deposit.

However, the dividends earned from Treasury-only funds and some government agency funds are free from state income taxes in most states. That may leave such money funds with a higher yield on a taxable equivalent basis than some of the prime money funds.

Investment instruments

Taxable money funds invest in a variety of instruments. The most common are listed below:

  • U.S. Treasury securities and direct obligations are backed by the full faith and credit of the U.S. Treasury. These can include short-term (three- and six-month) Treasury bills (T-bills) as well as repurchase agreements collateralized by T-bills.
  • U.S. government agency securities are backed by the moral obligation of the U.S. government and include obligations of such agencies as the Federal National Mortgage Association and the Small Business Administration.
  • Repurchase agreements, usually called repos, are short-term (often overnight) investment agreements. An investor agrees to purchase certain securities from the borrower today and the borrower promises to repurchase the securities at a specified date. The difference between the simultaneously negotiated price and the repurchase price is the investor's return. They constitute a fully collateralized overnight loan to a bank or securities dealer.
  • Certificates of deposit, or CDs, are short-term, actively traded instruments issued by banks or thrifts. These are usually issued in a $100,000 minimum and trade in $1 million units.
  • Commercial paper is unsecured, short-term (less than 270 days) corporate debt.
    Commercial paper is rated by nationally recognized ratings service organizations, such as Moody's Investors Service, Standard & Poor's, and Fitch Ratings.
  • Eurodollar CDs are offered by the foreign branches (usually located in London) of U.S. banks. The term can also apply to foreign branches of foreign banks; many are considered safer than some U.S. banks. Yankeedollar CDs and bankers' acceptances are sold by U.S. branches of foreign banks (usually in New York City).

Tax-Free Money Funds

Tax-free, or tax-exempt, money funds offer investors the advantage of earning income that is exempt from federal and, in some cases, state taxes. For those investors in higher tax brackets, the after-tax advantage of these funds can be quite significant.

Tax-free funds invest in short-term obligations of tax-exempt entities, such as state and municipal authorities. These pay daily dividends that are exempt from federal income taxes. Some also provide returns that are free of state and local taxes as well.

Tax-exempt money funds generally pay lower yields than taxable money funds. If you are in the 28 percent tax bracket or above, check to see if the lower yields on tax-free funds will generate higher after-tax returns for you than taxable funds.

To calculate whether you should be in a tax-free fund, use the following equation: Taxable equivalent yield = tax free yield/1 - (your marginal federal tax bracket). The "taxable-equivalent yield" is roughly equal to the return you would receive from a taxable fund. A tax-free investor should calculate the yield differences between tax-free and taxable funds to determine where he or she should invest. For example, an investor in the 28 percent tax bracket could consider investing either in a tax-free fund, which may be paying 3.0 percent, or a taxable fund, which, let's say, is yielding 5.0 percent. Using the formula [3 divided by (0.72)], the taxable-equivalent yield would be 4.17 percent. In this case, the investor would be better off in the higher-yielding taxable money fund even after paying taxes. For an investor in the 31 percent tax bracket, the taxable-equivalent yield would be 4.35 percent [3 divided by (0.69)]. He or she, therefore, would also earn a better after-tax return by investing in the taxable fund.

State-specific tax-free money funds

Individual investors who pay taxes in Arizona, California, Connecticut, Florida, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Carolina, Ohio, Pennsylvania and Virginia also have the option of investing in money funds that are free of federal, state and even local income taxes.

Tax-free investment instruments

To maintain their tax-exempt status, tax-free funds can only invest in particular securities:

  • General obligations bonds are issued by municipalities, and are backed by the full credit and taxing power of the issuer.
  • Revenue bonds are payable only from the revenues generated by the facilities being financed or from the proceeds of a special excise tax on other specific income sources, such as the users of the facility being financed.
  • Tax-exempt commercial paper is often issued by non-profit institutions, universities and economic development authorities, as well as state and local municipalities.
  • Short-term municipal notes include tax anticipation notes, bond anticipation notes, revenue anticipation notes and construction loan notes issued by state and local municipalities.
  • Most funds also retain the right to purchase some taxable instruments, such as U.S. government issues or highly rated commercial paper, when the supply of eligible municipal securities is low. See the fund's prospectus for more details.

AMT paper considerations

Although the purpose of tax-exempt funds is to provide tax-free returns, some money funds can purchase certain private-purpose bonds that may subject some shareholders to the Alternative Minimum Tax (AMT) section of the 1986 Tax Reform Act. Such bonds are issued to fund a project that is not clearly tied to public services, such as funding a new sports arena or convention center. Although many tax-free fund managers refuse to buy this paper, assuring that their portfolio remains tax-exempt for all shareholders, other managers do invest in the paper to earn better yields.

Check with your tax adviser to determine your AMT status, and then be sure to find out if a tax-free fund you're considering invests in taxable paper.

Safety—You Can Count On Money Funds

For years, money funds and safety were virtually synonymous. In fact, before June 1989, one could accurately proclaim that no modern money fund had ever invested in any money-market instrument that did not pay off at maturity. Then some things happened:

  • June 1989, a company called Integrated Resources defaulted on its commercial paper (which are unsecured promissory notes of corporations, with maturities of up to 270 days). Unfortunately, two money funds were holding some of the paper in their portfolios at the time. As a result, the money funds collectively lost about $32 million.
  • March 1990, a real estate investment trust called Mortgage & Realty Trust ran into similar problems with some of its own commercial paper, and this time at least seven money funds were holding this paper. The losses: $75 million collectively in defaulted commercial paper. Fortunately, the parent companies of the money funds which held the defaulted paper quickly jumped in and absorbed the losses, saving the funds' investors from any grief. Consequently, we can still say that no investor has ever lost money in a modern money fund.

Nonetheless, these two incidents prompted the SEC to impose more stringent portfolio quality, maturity and diversification restrictions on money funds in 1991, providing even more safety for investors.

  • In the spring of 1994, more than two dozen money funds were impacted by investments in money-market derivatives. Many of these funds had to be bailed out by their parent companies. In the most serious case, a small institutional money fund, Community Bankers Government Securities Fund, liquidated.
  • In December 1994, Orange County, Calif. declared bankruptcy, which forced several tax-free money fund companies to purchase the affected securities from their portfolios to avert problems. Again, no fund ever "broke the buck" and no investor lost any money because of the defaults.
  • In February 1997, Mercury Finance Corp. defaulted on commercial paper held by three Strong Money Funds.

Each of the money fund problems in 1994 and 1997 were severe and had the potential to cause losses for investors. Each time, however, the funds were able to overcome the difficulties and keep investors' money safe. This is a direct reflection of both the strict regulations under which the money-market fund lives, and the commitment the fund families have made to their portfolios. Were this type of crisis to occur in any other industry, the outcome would most likely have been far worse.

Safety a key benefit

Indeed, safety is still a virtue that is quite characteristic of the money fund industry. Of course, there are no bona fide ways to guarantee that problems similar to those mentioned above won't occur again. But generally speaking, you can count on money funds for safety.

Consider the following:

Short-term holdings - Safety is largely ensured simply because both taxable and tax-free money funds can only invest in money-market instruments with maturities of less than 13 months. More specifically, the average maturity of all holdings in a money fund cannot extend beyond 90 days. This prevents the "market risk" that bond funds have when interest rates rise.

Regulated diversification - Another safety feature is the SEC-enforced restriction that prohibits taxable money funds from investing more than 5 percent of their assets in a single issuer, with exception to government issues. This, of course, prevents the funds from major losses in the event of default on a particular money-market instrument.

Highly-rated paper - According to Rule 2a-7 under the Investment Company Act of 1940, money funds must limit their investments to securities that are rated high quality by a nationally recognized statistical rating organization (NRSRO). In fact, in 1991, the SEC mandated a 5 percent limit on the amount of middle-rated securities (rated A2, P2 or its equivalent by an NRSRO) that a taxable money fund may hold. But most funds have voluntarily restricted themselves even further than the SEC regulations, investing only in securities carrying the highest ratings.

Deep pockets - The integrity of money funds, as evidenced in the Integrated Resources and Mortgage & Realty Trust situations, demonstrates clearly that the interests of the shareholders—that is, the investors—are well served. In other words, the parent companies have shown a willingness to reach into their own pockets to pay for losses so individual investors don't suffer. Don't expect a bank or S&L to be so charitable.

New Regulations - The SEC provided new regulations for money funds in 1995. These regulations cover investments in derivatives and further guidelines for diversification and quality composition of the funds. As with the regulations added in previous years, these further enhanced the safety of all money funds.

Direct-Obligations-Only Money Funds—Maximum Safety and Attractive Tax Advantages

The "full faith and credit" advantage

Direct-obligations-only money funds offer the most protection, dollar for dollar. The reason? As the money fund category suggests, these are funds which invest only in the direct obligations of the U.S. government. Many of these invest in money-market instruments that are backed by the "full faith and credit" of the U.S. government. Such instruments include U.S. Treasury bills, as well as the obligations of Ginnie Mae (GNMA) and the Farmers Home Administration (FHA) federal agencies. That is not to say we're rejecting other money funds (see previous section for our comments on overall money fund safety), but for maximum security you won't find a safer money fund than a direct-obligations-only money fund.

A bonus: tax advantages

When considering direct-obligations-only money funds, bear in mind that safety is not the only advantage of such funds. If you invest in a money fund that holds only U.S. Treasury bills or direct-obligation notes from full faith and credit federal agencies listed above, there are attractive tax advantages as well.

Consider this, in at least 39 states such funds are considered exempt from state income taxes. That means those states will give you 50 to 100 basis points in yield just because the fund is investing solely in the safest investments in the world. What more can you ask for? Most importantly, however, is the fact that when you take the tax exemption into consideration, some direct-obligations-only money funds will actually outperform the top taxable money funds on a taxable equivalent basis.

How to Read the Prospectus

Before you buy shares of a money fund—or any mutual fund—you should read its prospectus. The prospectus is a document that is designed to inform the investor about the fund's objectives, its practices, its fees and its available services. You can use the prospectus to determine whether a fund fits into your personal investment strategy and, if so, how. A prospectus can be obtained by calling the fund's distributor. The prospectus provides instructions on how to purchase shares and includes an application to do so.

Objectives and investment policy

The prospectus tells an investor about the fund's investment philosophy. For example, most money funds will state their intention to obtain the highest level of income as possible while preserving principal and liquidity. As a rule, money funds regard the safety of principal, not the pursuit of yield, as paramount.

Other types of mutual funds (stock, bond, etc.), however, usually list income and/or capital gain accumulation as their primary investment objectives.

The portfolio and investment restrictions

As noted earlier, the type of money fund will sometimes dictate investment restrictions; government-only funds, for instance, will only invest in U.S. government obligations and those backed by U.S. government obligations. Other funds will specify the quality of the investments they can hold, noting acceptable ratings as assigned by major rating agencies such as Standard & Poor's, Moody's Investors Service or Fitch Ratings.

Some investment restrictions handed down by the SEC are applicable to all money funds. For example, the average maturity of a money fund's portfolio cannot exceed 90 days, nor can it invest 100 percent of a portfolio so that more than 5 percent is invested in the obligations of any one issuer. Most money funds restrict themselves even further than SEC regulations.

Fund management

Many professionals are officially responsible for fund management, such as directors, trustees and investment advisers. The portfolio manager, who actually manages the fund, may not be listed in the prospectus unless he or she is also an officer of the fund.

All funds have custodian banks that hold the assets of the fund (cash and securities) and transfer agents that handle the administration of shareholder accounts. The custodian bank and transfer agent will be named in the prospectus as well.

Services noted in prospectus

The combination of services offered to shareholders differs from fund to fund. Review fund literature carefully to determine which services are offered and which are most important to you. The following list provides some guidelines for you to consider when evaluating a fund:

  • Minimum initial investment. Some money funds that are open to consumers require only $250 or $500 as a minimum investment to open an account, while others, especially those geared toward institutional investors, require more than $10,000,000. Also, note the minimum subsequent investment, which is the smallest amount of cash you can deposit into an already-opened account.
  • Checking privileges. The check redemption privilege permits you to withdraw your money by writing a check for an amount equal to or exceeding the money fund's minimum check amount. These checks are, in effect, the same as any bank check and can be written to a third party. The typical minimum check allowed by a money fund is $500, although some funds have no minimums.

Some money funds provide unlimited checks to the investor at no charge, while others offer only a minimum amount. Funds usually offer confirmations of check transactions. Canceled checks or photocopies of checks are usually returned monthly, quarterly, or upon request.

  • Telephone redemption privileges. This privilege allows you to request, by telephone, that the fund redeem all or part of your investment. It is usually used to request that the fund wire the money to a bank account designated on your application.
  • Exchange privileges. Exchange privileges permit you to exchange shares of a money fund with shares of another mutual fund in the same mutual fund family. Investors who would rather be in a bond fund, stock fund or some other type of mutual fund will often switch their investments using this privilege. Some investors use this ability more aggressively than others, taking advantage of market swings and interest rate fluctuations. The procedures for using the exchange privilege vary among funds, so check each prospectus for limitations and restrictions.
  • Central asset accounts. Central asset accounts combine several financial tools—one or more money funds, checking privileges, debit or credit cards, and a securities or discount brokerage account—into one coordinated asset management program. Fees, the type of debit card, checking minimum and minimum initial investment vary from plan to plan.


In addition to comparing the services and advantages offered by each money fund, you should also look at the prospectus for the fund's expenses (which include management fees, custodial fees, transfer agent fees, legal fees, investment advisory fees and distribution fees) and its expense policy. Remember that, in most cases, the higher the expense, the lower an investor's total return.

Not all funds fully charge the fund's incurred expenses to the shareholders. Many funds use expense policy as a tool to boost yields and attract shareholders. Thus, many funds waive all of their expenses or absorb part of the charge to enhance their returns. In most cases, however, they reserve the right to begin charging at some future time. All funds are required to detail their expenses in their prospectuses. In fact, they also must include a hypothetical example that shows the amount of expenses that would be incurred over various time periods. An annual expense ratio of about .70 to .80 percent, or 70 to 80 basis points, is average for a retail money fund that is geared to consumers.

Some funds use a "12b-1 plan." The 12b-1 plan was created by the SEC to allow a fund to use fund assets to pay for marketing and distribution expenses. These include sales commissions as well as advertising and prospectus printing. While generally accepted, 12b-1 fees should be viewed by an investor as simply another expense when selecting a fund.

Measuring fund performance

Once you've decided on a fund, you should keep track of how it is performing. Monthly statements and account activity confirmations are one way of following the yield. You can also call the fund regularly; most provide a toll-free number for customer service. Also, many newspapers run weekly tables or provide these tables on their Web sites (from iMoneyNet's Money Fund Report or from the National Association of Securities Dealers).

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