by Pamela Wisehaupt Tynan

Principal and Fund Manager
The Vanguard Group

The record gains by the stock market in recent years have captured the fancy of many mutual fund investors. Nonetheless, another type of mutual fund has attracted significant attention from investors — money market funds. Assets invested in money market mutual funds totaled a near record of $1.7 trillion at the end of April 2000, according to the Investment Company Institute.

With the generous returns afforded by stocks, why consider investing in a money market fund? Principal stability, current income, and liquidity are three appealing characteristics of money market funds. This article explains the basics of money market funds and helps you choose a suitable fund as part of a balanced investment program.

The ABCs of Money Market Funds

Money market funds are diversified portfolios that are composed of short-term securities of creditworthy corporations, banks and other financial institutions, and federal, state, and local governments. U.S. Treasury bills and bank certificates of deposit, for example, are common holdings of money market funds.

There are two distinct categories of money market funds. So-called taxable money market funds pay dividends that are subject to federal, and possibly state and local, income taxes. Taxable money market funds include:

• U.S. Treasury Funds invest primarily in direct U.S. Treasury obligations whose principal and interest payments are backed by the "full faith and credit" of the U.S. government.
• U.S. Government Funds hold high-quality obligations of the U.S. Treasury as well as agencies of the U.S. government.
• General Purpose Funds invest in the short-term debt of large, high-quality corporations and banks.

The second category of money market funds is known as tax-exempt or municipal money market funds. Tax-exempt funds invest in short-term securities of state and local government agencies, and provide dividend income that is tax-free.

There are two basic types:

• National Tax-exempt Funds invest in municipal obligations issued by state and local governments around the country. Such funds provide income that is free of federal income taxes.
• Single State Tax-Exempt Funds hold municipal obligations issued by state and local governments of a particular state. Such funds provide income that is free of federal as well as state and local taxes.

Money Market Fund Mechanics

Money market funds are designed to maintain a stable price (or net asset value) of $1.00 per share. The high quality, short-term nature of a money market fund's holdings virtually assures this share price stability. In addition, money market funds must adhere to strict regulations of the U.S. Securities and Exchange Commission, the government agency that regulates mutual funds, with regards to quality and maturity of the issues in which they invest. Note, however, the $1.00 per share price is not guaranteed, and neither the Federal Deposit Insurance Corporation nor any other government agency insures money market funds against loss.

The income earned by money market funds is typically paid to shareholders on a monthly basis. The yields on money market funds are tied directly to prevailing interest rates and will fluctuate as interest rates rise and fall. Current yields range from 4% to 6% on taxable money market funds and 2% to 4% on municipal money market funds.

You may establish a money market fund for a relatively modest sum, usually $1,000 to $3,000. Shares of most funds may be purchased without a sales charge or load. And money can be withdrawn without fees or penalties.

Most funds also offer free checkwriting privileges for amounts of $250 or more, which enables you to write checks to cover your major monthly expenses, such as a mortgage or car payment. And since the money market fund is a member of a mutual fund family, you can usually exchange shares into a stock or bond fund at no charge with a telephone call.

The Appeal Of Money Market Funds

Some 40 million Americans invest in money market funds, which hold appeal to investors for different reasons. Some novice investors find comfort in the relative safety of placing their assets in a fund that seeks to maintain a stable share price. Indeed, many financial planners recommend that investors hold an amount equal to three to six months living expenses in a money market fund for a "rainy day." Once such investors become more accustomed to mutual fund investing, they may seek to invest in vehicles better suited for longer term goals, such as stock and bond funds.

Money market funds are also suitable for investors seeking current income. Yields on money market funds are typically higher than those offered by bank accounts. Note, however, that prevailing interest rates can decline at any time, which would cause a fund's monthly dividend income to fall commensurately.

In some cases, investors "park" assets in a money market fund to save for a short-term goal, like a car or the down payment on a house. In this case, the principal value of the investment is preserved and the assets are readily accessible by check or bank wire.

Still others invest a portion of their investing dollars in a money market fund to offset the risk of their stock and bond fund holdings, whose share prices are subject to sharp and sudden fluctuations in value. Money market funds provide stability as part of a balanced investment program that also comprises stock and bond funds.

Finally, more sophisticated investors who trade stocks and bonds in a brokerage account typically establish money market funds. The fund facilitates trading activity by providing ready cash to buy individual securities and also serves as a repository for the proceeds from security sales.

Selecting A Money Market Fund

There are more than 1,000 money market funds in which to invest. How do you choose the right fund for your needs?

Your first step should be to determine the type of fund in which you wish to invest. Do you want the higher degree of safety of a U.S. Treasury fund, or do you wish to earn modestly higher yields in a general purpose fund?

Consider, too, your tax bracket. If you are in the 31% federal tax bracket or higher, a tax-exempt money market fund may make sense. To see if this alternative is viable, determine the "taxable equivalent yields" of the municipal money market funds you are considering.

Taxable Equivalent Yield = (Tax-Exempt Fund Yield) divided by (100% - Investor's Tax Rate)

If the resulting yield exceeds the yield for the taxable money market fund alternative, you may be a candidate for the municipal money market fund investment. If you are considering state tax-free money market funds, add your state and local tax brackets to the federal tax rate in the above calculation.

After you've narrowed the field to the type of fund that best suits you, the next step is to evaluate specific fund characteristics, such as costs, yield, and average quality. Many investors are naturally attracted to funds that offer the highest yields. There is some peril to that strategy as higher yielding funds may be achieving their advantage by investing in lower-quality money market instruments. Therefore, it is wise to check the quality of the fund's holdings. In taxable general purpose funds, consider funds with A1 or P1 ratings from the major rating services.

Waiving operating expenses is another yield-enhancing tactic employed by money market funds. Money market funds assess expense ratios (i.e., the cost of operating a fund) ranging from as low as 0.15% to more than 1.00%. On a $10,000 investment, these expense amount to $15 per year for a fund charging a 0.15% expense ratio to more than $100 for funds charging more than 1.00%.

Under the fee waiving practice, money market funds absorb all or a portion of their expenses and then advertise higher-than-average yields for a short and often unspecified time. Full fees are eventually restored (with a resultant drop in yields), frequently without any notice. Today, nearly 59% of such funds waive some portion of their fees according to IBC Financial Data. You should determine if a fund is gaining its cost advantage by maintaining low expenses over time, or simply waiving fees. To obtain a complete picture of a fund's costs, refer to a fund's prospectus.

Finally, consider the sponsor offering the fund and the accompanying services such as checkwriting, wiring, and exchange services. Most major mutual fund families offer several taxable and tax-exempt money market fund alternatives. A listing of low-cost money market funds appears on this site.

These perspectives are provided as background information and commentary from professionals in the mutual fund industry and other financial communities. They are not intended to be nor should they be taken as investment advice.