Money market mutual funds are mutual funds that invest in very short-term, highly liquid securities which are considered safe havens such as government securities or T-bills, certificates of deposit, and commercial paper.

The funds are easily accessible and are as good as savings accounts in terms of liquidity.
Money market mutual funds usually come with free checks or an ATM card for easy access to cash. There are various other benefits including: -

• Anytime withdrawal without penalty unlike a CD which has a minimum holding period and early withdrawal penalties; easy redemption processes, either online or by phone.
• Easy set up;  it can be initially funded by linking to the checking account.
• Money market funds are considered cash equivalents.
• They are considered safe instruments as the SEC requires that money market funds invest as much as 95% of their assets in “first-tier” securities such as T-bills and top rated privately-issued paper.

Money market mutual funds

The returns are often higher than on money market accounts than on savings. Further, investors can link their brokerage money market funds to their stock or bond funds and “sweep” dividends or interest paid on the latter investments into the money market funds to start earning returns immediately. Proceeds from stock or bond sales can be “parked” in the money market funds until new opportunities are found.

Investors in the higher income brackets may benefit from tax-exempt money market funds which invest in bonds and securities issued by municipalities and state governments.

There are some risks in that the NAV can fall below $1.00, although that is rare, and some money market funds will charge a management fee. Further, some brokerages require minimum amounts for money market funds e.g. in the case of Charles Schwab, minimum investments start at US$2,500. The higher the investment and the minimum balance maintained, the more attractive the yield. Some online providers forgo the minimum.

Money market funds are regulated by Rule 2A-7 of the 1940 Investment Company Act, and as a rule, redemptions have to be paid out within 7 days.

If you are looking for a bit more risk and return then check out this article on high yield money market funds.

One question that often comes up when deciding on how to invest is the choice of investment vehicles.  If you want to buy low cost investments then index funds and exchange traded funds (ETFs) are the best choices.

Most investors are better off with index funds for a number of reasons – however it really depends on the individual situation.  Let’s take a look at some of the differences between these two investment types first.

Exchange Traded Funds – ETFs

• Lower ongoing management costs (MER).
• Higher trading fees.
• Manual orders (ie you have to sign in and order each purchase).

Index funds

• Higher MERs.
• No trading fees.
• Orders can be automated.

Since most investors tend to make purchases on a regular basis, the trading fees on an etf will quickly eliminate any advantage of the lower MER.  This means that index funds are often a cheaper alternative.

Another factor is the size of portfolio – if the portfolio is large enough then ETFs might make more sense.  The MER savings on a larger portfolio might outweigh the higher trading costs.

Keep in mind that not all ETFs are cheaper than index funds and trading and annual account fees can vary quite a bit between institutions.

Best solution

Most smaller investors (less than $100k) are likely better off with index funds because of the lower trading fees.

Larger investors have more choice – they can keep going with index funds, or switch to ETFs or perhaps own both.

Once you have a large enough portfolio, you can consider having the bulk of your portfolio in ETFs and then make regular contributions into index funds.  This way you get the low MERs of ETFs and have cheap trades with index funds.

More information

Should I Buy ETFs Or Index Funds?

Thanks to Green Panda Treehouse (a personal finance blog) for this post suggestion.

If you own a mutual fund, index fund or exchange traded fund (ETF) then you pay a fee called the management expense ratio (MER) or “expense ratio”.  This money goes to pay for the cost of running the fund.  It’s important to note that this fee is not directly charged to the investor but rather to the fund itself.  It will never appear on any transaction order form or account statement.

Why do I care about the MER?

The fees charged to the funds you own will reduce the return you get.  For example if you have a mutual fund that got 7% last year and then charged a 1% fee, then the return you will see is 6% – a 1% difference makes a huge difference over a number of years.  Generally speaking, the lower the fees are, the better off the investors are since they get to keep more of their own money.

Know your fees

It is the responsibility of the investor to know what kind of fees they are being charged.  If you have an advisor you can ask them or you can just look it up yourself.  Make sure you do this!

You should be able to go to the website of whatever company’s funds you own to look up the MER or you can go to a site like Morningstar.com which contains this information for all mutual funds.

Index funds typically have lower MERs than managed mutual funds because they don’t have to pay the portfolio managers as much.  ETFs can be cheaper than index funds.  Vanguard charges MERs that are among the cheapest in the industry.

Some examples

Here are some ETFs and funds and their MERs (the trading symbols are in brackets):

• Vanguard Total Stock Market Index (VTSMX) – MER = 0.15%
• Vanguard Total Stock Market ETF (VTI) – MER = 0.07%
• Aim Large Cap Growth Inv (LCGIX) – MER = 1.24%

An index fund is a mutual fund that invests in the same stocks that are contained in a stock market index, in the same proportion as the stock index.

Imagine a stock index – let’s call it the ABC index – that contains 2 stocks:- American Express and Kraft.  Let’s say that the ABC index is made up of 60% American Express and 40% Kraft.  If an index fund is based on the ABC index then it too will also invest in American Express and Kraft – 60% of the index fund will be American Express and 40% will be Kraft.

These percentages will change as the values of American Express and Kraft change.  If the price of the American Express stock increases and the price of Kraft decreases then the index will change so that maybe 65% will be American Express and only 35% will be Kraft.

An index fund can mimic any type of index.  Different indexes can follow a broad stock market index such as the S&P 500 or Dow Jones or something a lot more specific such as junior mining stocks.  Indexes can also cover non-stock investments such as bonds or commodities (such as oil).

The two main theories behind index funds (and passive investing) are as follows:

1)  Most managed mutual funds can’t beat their index over any length of time and it is impossible to predict which ones will beat the index in any given time period.

2)  The significantly lower costs of index funds will ensure that on average, index fund investors will have better returns than their managed mutual funds counterparts.

Photo by evolutionary journeyman.

Target retirement funds are mutual funds that are geared toward investors that have a specific target retirement date.  The idea behind these funds is they change their asset allocation over time to meet the needs of the investor.

If your planned retirement date is far away (say 25 years) then the fund will have a more aggressive asset allocation with a higher proportion of stocks compared to bonds.  If there is less time to retirement – then the fund will probably have more bonds than stocks.

The key difference between these funds and other mutual funds is that they will change their asset allocation over time to reflect the shortening of time to retirement.  Other types of mutual funds either never change their stock/bond ratio or only do so according to market conditions.

Target retirement fund example

If you are planning to retire in the year 2035 then you might buy an ABC Target Retirement 2035 fund.  Since that year is pretty far away, this fund will have significantly more stocks than bonds.  Most funds of this type would probably have around 80% stocks and 20% bonds.

If your retirement is only a few years away – let’s say in the year 2015 then you might own an ABC Target Retirement 2015 fund.  A rough estimate of the asset allocation might be 80% bonds and 20% stocks.

Pros of target retirement funds

• These funds are easy – they save you the work of continually monitoring and changing your asset allocation.

Cons of target retirement funds

• Potentially higher costs for the same reason as balanced funds.
• One size fits all doesn’t necessarily fit you.
• Effectiveness is reduced if you own other investments.  If half your investment is a target retirement fund and the other half is in stocks – then you are defeating the whole point of owning one of these funds.

Photo by Jeff Harmon Photography

Many mutual funds invest mostly in stocks or bonds.  Balanced,asset allocation, and target retirement funds invest in stocks, bonds and cash.

Reasons behind these funds

• One stop shopping – Rather than an investor buying an stock fund and a fixed income fund, they can just buy one balanced fund which will simplify their portfolio.
• Manage risk – Funds with higher stock allocations typically experience higher volatility.  Fixed income investments tend to have lower returns but are less volatile.  Balanced funds attempt to find a happy medium where the volatility is reduced but the returns are high enough to be acceptable.
• Market timing – Another feature of some of these funds is the ability of the fund manager to increase or decrease the allocation of either stocks, fixed income or cash – this is known as market timing.  For example is a fund manager feels like stocks are going up then they might increase the portion of stocks in their fund and decrease the fixed income and/or cash portion.  On the other hand if they think stocks are going to decrease in value then they might lower the stock allocation and increase the fixed income portion.

Things to watch for

• High fees – Stock funds typically charge higher fees than fixed income funds so if a balanced mutual fund has both stocks and fixed income then the fees charged should be somewhere between the stock fund fees and the fixed income fund fees.  Often the fees for balanced funds are similar to that of equity funds.
• Stocks/bonds split - Because these funds often change their asset allocations, it can be difficult for an investor to calculate the amount of stocks and fixed income in their portfolio if they own balanced funds.  It’s easier to track your allocation if you just own pure stock or bond funds.

Mutual funds are investment funds that are run by a professional portfolio manager.  The portfolio manager uses their knowledge and experience to decide what the best investments are for their mutual fund.

There are many types of mutual funds which can invest in different combinations of investments depending on the type of the fund.  All mutual funds will hold at least a small amount of cash in addition to their regular investments.

Here are some general types of mutual funds and the types of investments you might find in them:

• Equity funds –  These usually hold stocks of companies, possibly exchange traded funds (ETFs) and options in some cases.  An example of an equity fund is Franklin Growth Fund.
• Bond Funds –  These hold fixed income investments such as bonds and preferred shares.  An example of a bond fund would be Vanguard Total Bond Market Index.
• Balanced funds – these are a combination of equity and bond funds. These funds can hold any type of investment that an equity fund and bond fund can hold.  An example of a balanced fund would be American Balanced Fund.
• Target Retirement Funds – Similar to balanced funds but are geared towards a particular retirement date.

Keep in mind that index funds are also mutual funds, they are just a particular type of mutual fund.

There are also more specific types of funds available concentrating on a particular industry or geographic region.  For example a country-specific fund will only invest in companies from a particular country.  Franklin India Fund is a country-specific fund that only invests in Indian based companies.

An industry fund would be a fund that only invests in one industry such as oil.  An oil based mutual fund might invest in oil producers, refineries, gas stations etc.