Recent developments highlight the difference between money market accounts and funds

Money market accounts. Money market funds. There's just a one-word difference between the two names, but in this case, that word makes a world of difference.

Money market accounts and money market funds are similar in that they are both considered short-term, cash equivalents. As such, they are expected to be free from the risk of loss of principal, but only money market accounts can truly make that claim. This difference was highlighted during the 2008/2009 financial crisis, and a recent article in The Economist demonstrated that this difference is just as significant today.

Unfortunately, something as simple as the similarity of names between money market accounts and money market funds can confuse some consumers. This could lead to a costly mistake for someone seeking safety.

Structural differences

Money market funds are essentially like mutual funds, with their investment performance dependent on the specific securities held by the fund. While these are predominantly short-term income investments, the risk profile of those investments can vary greatly.

As for money market accounts, banks may invest some of those deposits in similar investments, but there are two important differences:

• A money market account is a general obligation of the bank, and thus has a broader reserve to draw on than a specific pool of investments.
• Even more critically, money market accounts are backed by the Federal Deposit Insurance Corporation (FDIC), up to $250,000 per depositor within each institution. This federal backing gives money market account customers an iron-clad guarantee of their deposits.

When the value of some large money market funds declined during the financial crisis, the federal government did step in with a temporary guarantee of their value. However, the government was not obligated to do so, and this temporary guarantee has expired. Given the criticism of the Wall Street bailout, it is far from certain that such a voluntary guarantee would be forthcoming in the future.

Meanwhile, as the financial crisis starts to recede in the rear-view mirror, momentum for improved regulation of money market funds has faded. That leaves the safety of investments in those funds largely dependent on the practices of the fund managers.

Investment trends

So what are money market fund managers doing these days? Well, the good news is that according to The Economist, money market fund exposure to corporate bonds has dropped from about 60 percent in 2006 to 30 percent this year. The bad news is that the exposure of money market funds to European banks is now at around 45 percent. That's cause for investors in money market funds to hold their breath every time they hear news about the debt crisis in some European Union countries.

Despite this risk, money market funds still attract $2.7 trillion in assets. The danger is, with money market rates generally low - in both funds and bank accounts - consumers will be drawn to the highest-yielding products. For money market accounts in FDIC-insured institutions, this is no problem - as long as you stay within FDIC insurance guidelines, the risk from one bank to another is essentially the same.

In contrast, the highest yields on money market funds could be a sign of the riskiest investments. That's why the word of difference between money market accounts and money market funds can make a world of difference to conservative investors.

Showing 1 comment | Add your comment