In September, the Federal Reserve began its rate-cutting cycle. However, that hasn’t discouraged investors from pouring money into U.S. money-market funds.
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According to Bloomberg , the assets under management in these mutual funds crossed a record $7 trillion last month. So they’re clearly still pretty popular despite the fact that they will deliver lower returns as interest rates are cut.
If you're feeling skittish about the economy in the wake of the recent election, you're probably not alone. You may gain some financial security by putting your cash into a money market fund. But you should know that there are some drawbacks to consider, too.
What is a money market fund
Some people use the terms money market fund and money market account interchangeably. That's a mistake, since they're not the same thing.
A money market account combines the features of a savings and checking account so you're able to earn a return on your money while also writing checks and taking cash withdrawals against your balance. Money market accounts get to enjoy FDIC protection of up to $250,000 per depositor, per institution.
A money-market fund (MMF), meanwhile, is a type of ultra low-risk mutual fund that doesn't come with FDIC protection. MMFs consist of relatively safe assets like short-term debt securities. So technically, you can lose money in an MMF, whereas you can't lose money in an FDIC-insured money market account provided your balance is $250,000 or less.
Why investors are choosing to invest
It may seem curious that investors are flocking to MMFs at this time. One possible reason is that they aren't expecting interest rates to come down significantly in the near future.
"Few people seriously expect a return to ZIRP (zero interest rate policy). Indeed, since the Fed started easing in September, markets have begun pricing in fewer cuts and the implied terminal rate has risen by around a full percentage point, and MMF inflows have accelerated. While there are myriad alternatives to MMFs, all come with downsides," explained Jamie McGeever of Reuters . "Given the high levels of uncertainty surrounding the year ahead — from geopolitical tensions to questions about President-elect Donald Trump's unorthodox policy agenda – the environment is likely to remain cash-friendly."
“There’s little in the data to justify cuts in the current environment of strong growth and sticky inflation, especially with uncertainty around tariffs and the potential for deregulation contributing to animal spirits,” said Subadra Rajappa, head of U.S. interest rates strategy at Societe Generale, to Bloomberg. “If that’s the case, what’s the rush to move money out of MMFs and into other assets?”
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A big part of President-elect Trump's campaign was putting an end to inflation. But with plans to impose tariffs on foreign goods and crack down on migrant workers, the fear is that inflation will pick up rather than slow down. In fact, 16 Nobel Prize-winning economists penned a letter earlier this year warning that Trump's plans could cause a surge in inflation and lead to a less stable U.S. economy.
During periods of economic upheaval, the stock market can be volatile. So an MMF may be a safer place to park cash right now. Economic instability could also drive unemployment rates upward. If you’re worried about job loss, choosing a fairly liquid investment like a money market fund could be wise, as you’d be able to expect easy access to your money should you need it in the absence of a paycheck.
Of course, without a crystal ball, there’s no telling how the economy will fare in the next four years. But if your primary goal is stability, then adding money market funds to your portfolio could be a good bet.
However, you don’t want to get your asset allocation wrong and miss out on potential long-term returns from riskier investments like the stock market. The main rule of investing is to maintain a balanced, diversified portfolio that's appropriate for your investing horizon and financial goals. A popular rule of thumb is that cash and cash equivalents should make up between 2% and 10% of your portfolio.
Benefits of a money market fund
MMFs allow you to grow your money in a relatively safe manner. These funds offer the upside of being very liquid, and they’re not as risky as other mutual funds. Depending on market conditions, you may be able to earn a better return in an MMF than from a savings account or CD.
If you’re saving for a specific goal that’s four years out, like buying a house or retiring, then an MMF could be an appropriate investment.
Drawbacks of a money market fund
An MMF might seem like a great place to put your cash if you’re worried about near-term economic volatility. But there are some drawbacks to these funds you should know about.
First, you don't get the same FDIC protection as a savings account or CD, yet you may not get so much of a better return that it’s worth giving that protection up. But perhaps the biggest disadvantage of an MMF is that you may be looking at only modest returns.
Over a four-year period, playing it safe with your money makes sense if there’s a milestone like retirement coming up at the end of it. Otherwise, you may want to keep your money in an S&P index fund instead.
Say you put $10,000 into an MMF over the next four years. If you earn 3% a year, you’ve grown your balance to about $11,250. If you put that same $10,000 into an S&P 500 index fund that gives you an 8% return, which is a notch below the stock market’s historical average, you’re looking at $13,600 instead.
Now to be fair, there’s a flaw in this example. S&P 500 index funds are best suited for people with a longer investment horizon than four years. So if you only want to tie up cash for four years, then again, an MMF may be a sound choice.
But if you have a 10-year window before you might need to use your $10,000, then an MMF paying you 3% during that time grows your balance to about $13,400. An S&P 500 index fund paying 8% gets you to almost $21,600.
That being said, MMFs are a great way to diversify your portfolio with some safe and stable assets.
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This article provides information only and should not be construed as advice. It is provided without warranty of any kind.