Basics of Money Markets

Money market funds are a common component of most individuals' investment
programs. Investors have entrusted more than $800 billion to the mutual fund
industry's 1,300 money market mutual funds. Why are money market funds so
popular? A review of their basic characteristics will help explain the appeal 
of these types of funds.

Money market funds seek to provide a stable net asset value of $1.00 per
share, while providing a current level of dividend income. You should keep 
in mind that while all money market funds expect to maintain a steady net 
asset value of $1.00 per share, there is no assurance that they will be able 
to do so. Remember, too, that an investment in a money market fund is neither 
insured nor guaranteed by the U.S. government.

Money market funds purchase short-term loans ranging in maturity from one
day to one year. However, the average maturity of a money market fund's
holdings in total may not exceed 90 days. The extremely short average maturity
of money market funds virtually eliminates interest rate risk. That is, the 
principal amount you invest is relatively secure. Nonetheless, money market 
funds are exposed to high income risk. In other words, while price volatility 
is not a factor for money market funds, their dividends may decline 
dramatically over a short period of time.

The investment holdings of money market funds are generally of exceptionally
high quality. Indeed, the SEC requires that all taxable money market funds
invest at least 95% of their assets in securities of the highest grade, as 
rated by major credit rating agencies such as Moody's Investors Services or 
Standard & Poor's Corporation. As a result, credit risk is virtually 
non-existent with money market funds.

There are three primary types of taxable money market funds. "Taxable" simply
means that the income provided by these funds is subject to Federal taxes (and
possibly, state and local taxes).

U.S. Treasury Funds 
These funds invest principally in direct U.S. Treasury obligations. Note
that the income provided by U.S. Treasury funds is taxed at the Federal
level, but is free of state taxes.

U.S. Government Funds 
These funds invest in obligations of the U.S. Treasury as well as agencies
of the U.S. Government. You may see these funds called "Federal"
money market funds, referring to the fact that they invest in obligations
issued by the Federal Government.

General Purpose Funds 
These funds invest principally in the short-term debt of large, high-quality
corporations and banks.

There is also another separate category of money market fund - the municipal
money market fund - that invests in the obligations of state and local 
government agencies. Municipal money market funds pay income that is exempt 
from Federal, and sometimes state and local, income taxes. These funds are 
often referred to as tax-free money market funds.

Most money market funds share similar service features, including free
checkwriting, free exchange privileges into other mutual funds in the same
family, monthly dividends, bank wire privileges, among others.

Besides quality, the main differentiating factor of money market funds is 
cost. Expense ratios range from a low of about 0.20% ($2 for every $1,000
invested) to 2.00% ($20 for every $1,000 invested). Other things being equal
(namely quality, in money market funds), lower costs mean higher returns for
investors.

One caveat: many of the money market funds promoting higher-than-average
yields today are achieving them by temporarily waiving some of their
management fees or absorbing other operating expenses. In fact, up to 60% of
money market funds employ this practice. Why are these funds waiving fees?
Apparently to create exceptionally high promotional yields that can be heavily
advertised. Then, after the funds attract a large asset base, they will apply 
their full fees and expenses. They are betting on shareholder apathy or 
ignorance, assuming that when the eventual reduction in yield comes, most 
investors will maintain their investments in the fund. To combat this 
misleading tactic, look for funds that maintain low expenses year after year, 
without resorting to short-term tactics to artificially boost yields.