What should you do with your cash? If you are saving for a new car down payment, or a vacation you want to take next year, or trying to build an emergency fund with 3 to 6 months expenses you have a short an investment horizon. It would be prudent to put your money somewhere that is both safe and provides a decent return. When you look at your back’s savings accounts you notice that they are returning about .25% …that’s not much of a return, CD’s are another possibility, but what if you need your money in an emergency (if your investment goal is to build an emergency fund)?

Money market funds are designed to maintain a one dollar share price (NAV or Net Asset Value) and you make money on your investment by receiving dividends that are paid out at the end of each period (usually one month). A money market mutual fund provides a little better return than your bank options (most offer a 2.5% yield at the time of this writing) and don’t subject you to market risk…or do they? Just how safe are money market funds? Are they all safe? How can you know which ones are safe?

There are three major factors to consider when assessing the safety and stability of money market funds. Maturity, credit quality and the firm’s overall stability should all be considered when deciding which funds to put your cash in. The stability of the company is important. Money markets are generally safe but have occasionally had to rely on the liquidity of the management company to maintain their one dollar a share NAV.

Money market funds in the US are created by SEC Rule 204a-7. The rule states that money market funds can not have an average maturity date over 13 months. A simple way to look at it is the shorter the term to maturity the smaller the financial risk (for short term instruments with the same credit ratings). Yields vary from one fund to another, some may hold longer term bonds. While all money market funds have to keep the average (dollar weighted) maturity below a 90 day window established by rule 204a-7, they can hold longer term paper. The Rule specifies that they can hold any type of paper with a “remaining maturity less than 397 days”.

Besides maturity the other important factor is the credit rating of the underlying securities. This is where the recent events in the banking industry make things a little dicey. Ratings firms have been hard hit in the recent credit crisis, many investors blame the credit rating firms (S&P, Moody’s etc…) for the liquidity collapse. This has made it harder for companies, even those who have maintained good credit ratings in the past, to sell their short term notes (often referred to as “commercial paper”). Along with this point you should also look for funds that are fully diversified and carry 5% or less of any one issuer’s paper as a percentage of total assets under management.

While there is no way to fully protect against systemic risk it should be noted that money funds have been, and remain, a bulwark of liquidity in an unstable and dangerous market. Since the beginning of the current financial crisis, a dozen firms have directly supported the liquidity of their money market funds to insure their share price didn’t “break the buck”(let the NAV fall below $1). This is when the overall financial stability of the management company comes to bear. Some analysts even attribute the stabilization of the financial market place to the steady hands and clear heads of money market fund managers who have kept their cool when many other investors have lost their bearings.

Here are some simple rules for choosing a money fund:

1. Only patronize the larger, most stable money funds. By this you should look to invest with the big names: Vanguard, Fidelity, T Rowe Price, Charles Schwab, etc…(the ‘first tier’ mutual fund companies, if you will, these larger companies have the advantage of virtually guaranteeing liquidity, which is especially important since money market funds are not protected under FDIC).

2. Read the prospectus, or at least the summary of each fund’s investment approach. For example, on Vanguard’s website they provide clear explanations of how each fund invests, their credit ratings and the average maturities of the assets held.

3. Beware of funds that have yields that are much higher than the average. Reaching for additional yield, which may look smart in the short term, tends to expose investors to higher risk levels. Since the purpose of investing in money markets is to protect value for short periods of time (money you have earmarked for growth belongs in stocks or long term bonds) the reward simply does not warrant the additional risk.

Following these guidelines should serve to protect your cash for short term needs. Money that will be spent in the next 2 years belongs in a money market. The goal for this asset class is to preserve and protect your savings so that it’s ready when you need it. Be careful and don’t overreach for yield…or you may end up with an empty bag when you need your cash the most.