Money Market Rates: Why Money Market Accounts Beat Money Market Funds, Hands Down

As of early December, the total amount invested in US money market mutual funds had declined by more than half a trillion dollars this year. Looking at the state of money market funds right now, you might well be inclined to ask, "Why only half a trillion?" If nothing else, current conditions underscore the distinction between money market funds and their banking counterparts, money market accounts.

Money Market Accounts vs. Money Market Funds

Despite the similarity in names, money market funds and money market accounts don't have that much in common. Notionally, they are both designed to earn interest for customers by investing in the money markets--basically, short-term debt instruments.

Under normal economic circumstances, when those short-term debt instruments are yielding a few percentage points in annual interest, there appears to be little distinction between money market funds and money market accounts. In today's environment, though, incredibly low yields have brought the differences into sharp relief.

Current Conditions Heighten the Differences

By late 2009, the average annual yield on money market funds was down to 0.03%. Simply put, money market funds were yielding virtually nothing. At the same time, the average yield on money market accounts listed on Money-Rates.com was 1.18%, with a number of money market account rates in excess of 1.5%. Why are money market accounts able to pay more than a full percentage point in interest more than money market funds? It has to do with how today's unusual conditions have heightened the impact of the fundamental differences between these vehicles.

For one thing, money market funds are mutual funds which must invest their assets in specific types of investments, while money market accounts are general obligations of the bank. This gives banks more flexibility to deal with today's extreme low-yield environment, which is why they can offer higher money rates.

Another key difference is fees. Banks don't typically charge a fee for money market accounts--they use them as a source of capital to fund other profit-making activities, such as lending and investment. Money market funds, on the other hand, charge a fee against fund assets, which subtracts directly from the yield on those funds. The average fee on money market funds is approximately 0.38%. This would be barely noticeable if those funds were yielding, say, 5%, but when yields drop below 1%, that fee suddenly becomes an extremely heavy burden.

In fact, with money market funds yielding 0.03% and the average fee at 0.38%, it means that if you invest in a money market fund right now, the fund is earning more than ten times as much as you are.

Why Invest In Money Market Funds At All?

Given all of the above, you might wonder why there is still over $3 trillion invested in money market funds. One explanation is flexibility. Money market funds are often used in conjunction with active investment accounts, allowing cash to move freely into and out of stock and bond investments as opportunities arise. In fact, two-thirds of the assets in money market funds are held by institutional investors--pension funds, endowments, and the like.

Aside from this flexibility, it's hard to see a reason for favoring money market funds, and particularly not for individual investors. Take all of the above conditions and throw in FDIC insurance for bank deposits, and money market accounts have the clear advantage.

Source: