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What is a money market fund and how does it work?

February 12, 2024

Written by Robb Engen

Key takeaways

  • Money market funds are a form of mutual funds that contain a diversified portfolio of short-term fixed-income investments.
  • They can be an appealing option for risk-averse investors seeking to protect their investment from market fluctuations.
  • The low risk of money market funds lies in their conservative investment approach, focusing on high-quality, short-term securities. However, like any investment, they are not entirely risk-free.

What is a money market fund and how does it work?

Money market funds have long been considered a safe haven for investors to park their cash and earn some interest. An investment that aims for low risk and liquidity, money market funds were largely forgotten during the low interest rate era of the 2010s – when the interest paid by such funds remained very low for long periods.

But money market funds have become more popular now that interest rates have gone back up. This article will explore the inner workings of money market funds and why they are a popular choice for some investors seeking a balance between low risk and returns.

How do money market funds work?

Money market funds are a form of mutual funds. Your money is pooled with everyone else’s who has contributed to the fund. That pool of money is then invested in a diversified portfolio of short-term fixed-income investments that are issued by federal, provincial, and municipal governments, chartered banks, trust companies, and corporations.

The underlying investments are low risk and typically have a very short average term to maturity of one to three months. This can make money market funds an appealing option for risk-averse investors who wish to protect the value of their investment even in times of market volatility. It also makes these funds suitable to use for short-term investment purposes.

One of the key attractions of these funds is their liquidity – investors can easily buy or sell on any day, making them accessible for quick capital needs.

Investors can purchase money market funds through various financial institutions, including online brokerages and mutual fund dealers. Investors can hold money market funds in accounts such as Registered Retirement Savings Plans (known as RRSPs or just RSPs) or Tax-Free Savings Accounts (TFSAs), providing flexibility in managing their investment portfolios.

Your financial institution may also require a minimum initial investment and that you maintain a certain balance in the account. With Tangerine Investments, investors can get started with as little as $25.

Advantages of money market funds

Money market funds have some key benefits that may make you consider including them in your investment portfolio.

Stability: Money market funds aim to offer protection from market volatility, making them a reliable choice for risk-averse investors. 

Return on cash: Many investors maintain a cash balance in their investment accounts for rebalancing purposes, to take advantage of dips in the market, or due to benign neglect. Often, this cash is not invested in anything. A money market fund offers investors a chance to earn a respectable yield on this cash.

Disadvantages of money market funds 

While money market funds offer numerous advantages, it's crucial to consider their potential drawbacks. 

Limited returns: Compared to riskier investments, you may not make as much money with a money market fund. 

Vulnerable to economic changes: Money market funds are susceptible to changes in interest rates, which can impact yields. And there’s the possibility that inflation may erode the purchasing power of your returns.

Not every money market fund is created equal: While money market funds are once again paying a decent rate of return, there is a wide discrepancy in interest rates amongst funds and fund providers. Investors need to compare options and choose a money market fund that pays a competitive interest rate after fees.

Advantages
 
  • Stability
  • Return on cash

Disadvantages

  • Limited returns
  • Vulnerable to economic change

What is the difference between a money market fund and a savings account?

Money market funds and savings accounts share similarities, such as stability and liquidity, and they both pay interest regularly. However, they differ in structure and returns. 

  • A savings account is typically held with a bank or credit union. It offers an interest rate set by the institution that can change from time to time. Money market funds are mutual funds that put your money in a portfolio of short-term investments. The interest rate you earn will tend to fluctuate over time.
  • The slightly higher risk of a money market fund comes with the potential to earn a bit more income than you usually would with a savings account.
  • Eligible savings accounts from financial institutions (including Tangerine Bank) that are members of the Canadian Deposit Insurance Corporation offer protection of up to $100,000 if the institution becomes insolvent. Money market funds do not come with CDIC protection.
  • Many savings accounts don’t charge monthly fees, though they might have fees for withdrawals and deposits. Also, they typically don’t have minimum deposit requirements or minimum holding periods. Money market funds, like other mutual funds, will include a management fee and possible account minimums.
  • A money market fund is helpful for money earmarked for investment purposes, while a savings account is normally used for more short-term goals and emergency savings.

Which is better: a GIC or a money market fund?

Choosing between a Guaranteed Investment (GIC) and a money market fund depends on your individual needs and financial goals. GICs offer a fixed interest rate for a specified term (typically one to five years). Unlike a money market fund, your initial deposit is CDIC protected up to the same maximum amount as a savings account, but in most cases you can't access these funds until the term is up. The security of a GIC comes with limited liquidity.

Money market funds can provide more flexibility and liquidity, making them suitable for those who prioritize quick access to funds. 

GICs pay interest at the end of the term, while money market funds pay interest regularly.

Are money market funds safe investments?

The low risk of money market funds lies in their conservative investment approach, focusing on high-quality, short-term securities. However, like any investment, they are not entirely risk-free.

One pitfall today’s investors should be aware of is that interest rates on money market funds are not guaranteed. If interest rates in the broader market decline, money market funds will in turn reduce the rates they pay investors. This could surprise those who parked money in a money market fund, thinking they’d always get the same rate of return. 

Who should invest in money market funds?

Money market funds are well-suited for investors seeking a conservative investment option focusing on stability and liquidity. They are particularly attractive for those who want to have quick access to their funds if needed, and who prioritize keeping their investments intact over the potential for higher returns.

However, investors with a higher risk tolerance or who seek higher potential long-term growth may want to explore alternative investment options. As with any financial decision, it's essential to align your investment choices with your individual financial goals and tolerance for risk.

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