How to Choose the Right Money Market Fund

You might be surprised to hear us say this, but money market mutual funds have become indispensable investment tools.

A successful portfolio is one that spreads the risk over a number of different kinds of investments: stocks for growth; bonds and CDs for income; municipal bonds and Treasuries for tax advantages and safety; and money market mutual funds for liquidity.

Money market funds are great because they act like checking and savings accounts but usually pay higher interest rates than you can earn on your bank accounts. But there's one important difference: Money market funds are not insured like bank accounts.

Here's how they work: Money market funds issue and sell shares at $1 each and always stand ready to be redeemed at $1. In the meantime, they can invest only in the two highest grades of commercial paper and they must keep their maturities—the point at which the debts become due—at 120 days or less. Because the market price of short-term investments fluctuates much less than that of long-term investments (such as 30-year Treasury bonds), short-term debt is inherently safer.

As safe as money markets sound, you should still be picky. In general, money market funds come in four varieties. In descending order of safety, they are:

1. U.S. Treasury funds. These funds eliminate the risk of default by investing solely in short-term Treasury securities, which are guaranteed by the federal government. These funds are generally free of state and local taxes.
2. U.S. government and agency funds. These funds invest in bonds and notes of federal agencies whose credit is implicitly, but not explicitly, guaranteed by the Treasury and by Congress. This very slight extra risk (over U.S. Treasury funds) boosts the fund's yield. These funds are usually free of state and local taxes.
3. Diversified taxable funds. These funds keep the bulk of your money in the commercial paper of U.S. corporations. They may also own Treasury and agency paper and bank CDs.
4. Tax-free funds. These money market funds invest in short-term tax-exempt securities of state governments and municipalities, and they pay income that is free of federal taxes. Some tax-free funds invest only in the securities of a single state. This income is then free from state and local taxes as well. But beware, because these funds are less diversified, they are also more risky.

Dolan Smart Money Move: In general, we recommend buying U.S. Treasury money market funds. The yield may be a wee bit lower than that on other money markets, but the safety and tax advantage can't be beat.

More Investing Wisely Strategies:

• Go For the Dividend
• What the Heck are Bonds Anyway?
• How to Invest in a Volatile Market