Are Money Market Funds Safe

At times of economic turmoil, people seek safe investments. The idea of making a risky investment that might pay off with a big gain seems preposterous during a recession. But, of course, an investor still wants to earn some money on his or her investment, rather than sticking money under a mattress.

Money market funds are one great option for getting a small-but-safe return. Invented nearly 40 years ago, money market funds have boomed during any time when the economy struggled. There were more than 2,000 money market funds in the U.S. as of the start of 2008, and they saw a significant increase in assets throughout the year as the stock market performed poorly. More than $5 trillion is invested in them in the U.S. alone. For investors looking to protect their nest eggs, the money market fund has been pitched as the safest investment around. But is it?

A money market fund is similar to a mutual fund. Its managers make a series of investments and manage those to maximize the financial return. But whereas mutual fund managers can invest in stocks, money market fund managers are legally required by the Securities and Exchange Commission to invest only in securities with very low risk. Their goal is to do a little better than you can do in a savings account (maybe earn 3% per year) – but to never lose money. A typical mutual fund, of course, can do better than 3% per year, but it can also lose a fair amount in the short term if its managers make bad bets.

Money market funds typically invest in government securities, certificates of deposits, and commercial paper of ultra-safe companies (loans). In other words, they make the safest investments, and they sit on them for a long time, just gathering up the interest and passing along most of it to their clients (and skimming some as their profit).

It’s a simple system. However, it doesn’t mean that a money market fund can’t lose money. The funds are not the same as a savings account in bank – where an investment earns a guaranteed rate of interest, and the federal government insures loans of up to $100,000 per person. In a money market fund, an investment company is making investments, and the amount the investor gets back is based on the company’s ability to make good decisions. Sometimes, the company makes bad decisions, and a fund can record a loss. This point must be emphasized: Money market funds are not guaranteed to make money.

Occasionally, a manager of a money market fund will make a series of bad bets, and will invest in companies that can’t pay their debt, or have some other problem. At this point, if the securities that the fund owns are not being paid off, the Net Asset Value (NAV) of the fund may fall below $1.00 per share. In other words, the investor put in $1.00 per share, but the share is only worth $0.98, or $0.96, or whatever. The investor has actually lost money.

This has occurred in 2008 for the first time in many years. At least a dozen money market fund operators have had to put money into their funds in order to keep the Net Asset Value at $1.00 per share. These included household names such as Legg Mason, Credit Suisse, and Bank of America. Each of these companies had to buy shares in its own money market fund in order to bring the NAV back to $1.00/share.

Here’s why they did it: The reputation of an investment firm would be ruined if it could not maintain the NAV of a plain-vanilla money market fund. It would indicate that the firm can’t do the simplest thing right. In other words, Legg Mason knew that if it didn’t prop up the value of its money market fund, its investors would pull all their money out and go to another money market fund operator – and Legg Mason would be in terrible financial trouble. In practical terms, any firm will compensate any money market fund holder so that he or she doesn’t have a loss.

So, the bottom line is that a money market can lose money. Although it is one of the safest investments around, but it’s not foolproof. However, it’s very unlikely that an investor will actually record a loss in a money market fund because the manager of the fund will always make up the difference. Unless the manager is going bankrupt, and then all bets are off…