The safest and most basic type of mutual fund investment is a money market fund.
Money market funds have a long history as stable investments that seek to maintain a constant net asset value of $1 per share. When a money market fund's NAV slips below $1 a share, it's called "breaking the buck."
Breaking the buck seldom occurs. As a result, share prices of money market funds are more or less pegged at $1 a share. Investors earn income from the fund's distributions of dividends and capital gains rather than on capital gains that may occur when they sell shares.
At the end of November 2007, money market mutual funds had nearly $3.07 trillion in assets, or 25.5% of the $12.08 trillion invested in all mutual funds, according to the Investment Company Institute (ICI), an industry group that represents mutual fund companies.
Since their share prices do not fluctuate the way prices of stock and bond funds do, and since they have an average maturity of less than 91 days, a money market fund's price is often stated in terms of its simple or compounded yield. Often, a money market fund's yield is shown for seven- and 30-day periods and annualized to make it easier to compare returns.
For example, a yield of 1.6% indicates that, on average, a money market fund generates $1.60 in income for each $100 invested. The Federal Reserve influences yields on money market funds through its use of monetary policy. Between June 2004 and June 2006, the Fed raised short-term interest rates 17 times, leading to sharply higher money-market yields through the middle of 2007. Between September 2007 and December 2007, the Fed lowered the interest rate three times.
Money market funds are available as taxable or tax-exempt funds. Taxable money market funds invest in securities whose income is not exempt from federal income taxes, including funds that invest principally in Treasury securities. Tax-exempt money market funds invest in short-term securities whose income is exempt from federal income taxes, such as bonds issued by state governments and municipalities.
Assets in taxable money market funds dwarf those held in tax-exempt funds. In part, this may be due to the relative scarcity of tax-exempt funds and the fact that investors often keep money market funds for short periods of time before deploying those assets elsewhere. (Fund managers call this short-term strategy "fund-parking.")
To help you evaluate a tax-exempt money market fund, you may want to look at its taxable equivalent yield. Taxable-equivalent yield calculates the yield you would have to earn on a taxable investment that would match the yield you earn on a tax-exempt fund.
To calculate the taxable-equivalent yield:
Subtract your federal income tax rate from 100. For example, if you are in the 25% income tax bracket, the difference is 75. This figure is also called your reciprocal-of-tax-bracket.
Divide the tax-exempt fund's yield by your reciprocal-of-tax-bracket. If the yield on a tax-exempt fund is 1.8% and your reciprocal-of-tax-bracket is 75, the taxable-equivalent yield is 2.4%.
In other words, you would have to earn a yield of at least 2.4% on a taxable money market fund to make the taxable fund more attractive than the tax-exempt fund.
If your tax-exempt fund is also exempt from state income taxes, subtract your combined income tax rate from 100. For example, if your federal and state income tax rates sum up to 40% of income, your combined reciprocal-of-tax-bracket is 60.
Using the same formula, a 1.8% yield on the current tax-exempt fund has a combined taxable-equivalent yield of 3%.