Risks of Money Market Funds

A money market fund is a type of fixed-income mutual fund that invests in debt securities with short maturities and minimum credit risks. As such, it is considered one of the least volatile assets on the market.

Investments that exhibit low volatility are less likely to generate market-beating returns, but they are necessary to ensure that your portfolio is well balanced. Depending on your risk profile, money market funds may comprise a significant portion of your portfolio.

Shortly after the 2008-09 financial crisis, money market funds had more than $3.3 trillion in assets under management, according to the U.S. Securities and Exchange Commission. Before the fall of Lehman Brothers, no retail investor ever lost a penny investing in a money market fund, or so it was claimed.

When Lehman Brothers went bankrupt in 2008, $40 billion was quickly pulled from the Reserve Primary Market Fund – a New York-based fund manager specializing in money market funds. That amounted to half its asset base. To meet withdrawals, Reserve had to sell other assets into a plunging market, pushing shares to $0.97 each. In money market funds, investors lose principal when a share’s net asset value falls below $1.00.

Fast forward to 2019, money market funds had nearly $3.5 trillion in assets under management, with more than half allocated to government and Treasury funds. While another Lehman Brothers scenario doesn’t seem likely in the immediate future, there’s no guarantee a similar collapse won’t happen again. For this reason, it’s important to be cognizant of the risks associated with money market funds.

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Money market funds are designed to hedge against volatility, but they are not inherently risk-free. Let’s go over some of the key risks.

Credit Risk

Unlike bank certificates of deposits (CDs) or savings accounts, money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC). While they invest in high-quality securities with a focus on capital preservation, money market funds are no guarantee that you won’t lose money.

Inflation Risk

Like other asset classes, money market funds also carry inflation risk, meaning their rate of return might not keep pace with the perpetual devaluation of the dollar. That’s why so many investors play the stock market as they want to ensure their wealth is growing faster than inflation.

Liquidity Risk

Investing in prime and municipal money market funds carries liquidity risk, which can impact your redemption schedule. These funds may temporarily suspend your ability to sell shares if liquidity drops below a minimum threshold.

Price Risk

In the case of prime and institutional municipal money market funds, there’s an underlying risk tied to price fluctuations. As share prices fluctuate, there’s a chance that they will be worth less than you paid for them when you decide to sell.

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Interest Rate Risk

The other obvious risk is the yield, which is the interest rate that fixed-income securities pay upon maturity. When yields fall, as they are now, the yield on money market funds also declines. This makes the opportunity cost of holding these funds rather high, especially in a bull market.

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Despite some of the risks, money market funds usually make a great addition to a well-balanced portfolio. To maximize your money market investments, consider larger funds like the JPMorgan US Government Money Market Capital (OGVXX) or the Vanguard Treasury Money Market Investor (VUSXX). These funds are safer, have higher liquidity, and are less likely to break the all-important $1 rule.

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Choosing funds that have a track record for safety is also important. Assessing things like credit quality, underlying fund holdings, and maturity dates can help you select safer investments.

One of the best ways to increase money-market returns without increasing risk is to select funds with lower fees. This is especially important in light of the inflationary risks mentioned in the previous section.

In a volatile marketplace, money market funds certainly have their place. However, investing in them isn’t without its pitfalls. Assessing the risks and the opportunity cost of holding money market funds should be common practice, regardless of how risk-averse you are.

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