How to use money market funds in your portfolio

Amy C. Arnott, Morningstar

Money market funds are mutual funds that invest in high-quality, short-term debt instruments, including U.S. Treasury bills and commercial paper. Their goal is to maintain a stable net asset value of $1 per share while offering yields that are typically higher than traditional savings accounts.

These funds are widely used by both individual investors and corporations as a practical tool for managing cash. Available through most major brokerage platforms, they often come with features such as check-writing and easy transfers, making them convenient for covering large expenses like tax payments or reallocating funds into longer-term investments.

Most assets in the category are held in taxable money market funds, which invest in securities such as Treasury bills, short-term government obligations, and high-quality floating-rate debt. Because these instruments have very short maturities – often measured in weeks or months – they carry minimal interest rate risk. As older holdings mature and are replaced, yields tend to adjust quickly to prevailing interest rates.

One of the key attractions of money market funds is their relative stability. They are generally considered safe, as they aim to preserve capital and avoid price fluctuations. However, this stability comes at a cost. Over the long term, money market funds have delivered some of the lowest returns among major asset classes. Since they do not offer capital appreciation, their performance depends entirely on income generated from yields, which can vary significantly depending on the interest rate environment.

Importantly, money market funds are not risk-free. Unlike bank deposits, they are not insured by the Federal Deposit Insurance Corporation. On rare occasions, funds have “broken the buck,” meaning their net asset value fell below $1 per share. Historical examples include losses in 1978 and 1994 tied to interest rate movements and derivatives exposure. The most notable stress occurred during the global financial crisis, when some funds were affected by defaults on commercial paper. In 2008, the Reserve Primary Fund dropped to $0.97 per share following the collapse of Lehman Brothers.

More recently, liquidity pressures emerged in 2020 during the early stages of the pandemic. While several institutional funds faced strain, emergency support from the Federal Reserve helped stabilize the system and prevent losses for investors.

Regulatory reforms have since aimed to strengthen the resilience of money market funds. In July 2023, the Securities and Exchange Commission introduced new rules that tightened liquidity requirements, enhanced disclosure and stress-testing standards, and implemented mechanisms such as liquidity fees to mitigate risks during periods of market stress.

For investors, the role of money market funds in a portfolio depends largely on financial goals and life stage. Younger investors with long time horizons typically allocate only a small portion to cash, assuming they have already set aside an emergency fund. In contrast, those approaching or in retirement are often advised to hold one to two years’ worth of expenses in cash or similarly low-risk assets. This buffer helps avoid selling longer-term investments during market downturns.

In essence, money market funds serve as a reliable, flexible parking place for cash. They are not designed for growth but can play a crucial supporting role in maintaining liquidity, managing risk, and providing stability within a broader investment strategy.

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