BUSINESS & FINANCE

What Is a Money Market Fund

A money market fund is a type of mutual fund that invests in short-term, highly liquid assets. These instruments include cash, cash equivalent securities, and debt-based securities with a high credit rating and a short maturity (such as U.S. Treasuries). Money market funds are designed to provide investors with high liquidity at a low risk. Money market mutual funds are another name for money market funds.

A money market fund is not the same as a money market account, despite their similar names (MMA). A money market fund is a type of investment that is sponsored by a fund firm. As a result, there is no main assurance. A money market account is a form of savings account that pays interest. Financial organizations provide money market accounts. They are FDIC-insured and often have restricted transaction rights.

How a Money Market Fund Works

Money Market Fund
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Money market funds function similarly to mutual funds. They sell redeemable units or shares to investors and are required to obey the rules imposed by financial authorities (for example, the Securities and Exchange Commission (SEC) in the United States).

A money market fund may invest in the debt-based financial products listed below:

  • Bankers’ Acceptances (BA)—short-term debt guaranteed by a commercial bank
  • Certificates of deposit (CDs)—bank-issued savings certificate with short-term maturity
  • Commercial paper—unsecured short-term corporate debt
  • Repurchase agreements (Repo)—short-term government securities
  • U.S. Treasuries—short-term government debt issues

Because the returns on these instruments are determined by the appropriate market interest rates, the overall returns on money market funds are likewise determined by interest rates.

Types of Money Market Funds

Money market funds are grouped into several forms based on the type of assets invested, the maturity time, and other factors.

Prime Money Fund

A prime money fund invests in non-Treasury floating-rate debt and commercial paper, such as those issued by companies, US government agencies, and government-sponsored enterprises (GSEs).

Government Money Fund

A government money fund invests at least 99.5 percent of its total assets in cash, government securities, and fully collateralized repurchase agreements in cash or government securities.

Treasury Fund

A Treasury fund invests in traditional US Treasury debt securities such as Treasury bills, Treasury bonds, and Treasury notes.

Tax-Exempt Money Fund

Earnings from a tax-exempt money fund are not subject to federal income tax in the United States. A tax-exempt money fund may also be exempt from state income taxes, depending on the specific assets in which it invests. Municipal bonds and other debt instruments are the most common forms of money market funds.

Some money market funds are designed to attract institutional money by requiring a large minimum commitment (typically $1 million). Other money market funds, however, are retail money funds and are available to ordinary investors due to their low minimums.

Special Considerations

The Net Asset Value (NAV) Standard

A money market fund has all of the characteristics of a normal mutual fund, with one major exception. A money market fund strives to keep its net asset value (NAV) at $1 per share. Any surplus earnings created by interest on portfolio holdings are paid to investors in the form of dividend payments. Shares of money market funds can be purchased or redeemed by investors through investment fund providers, brokerage firms, and banks.

One of the fundamental reasons for money market funds’ appeal is their ability to maintain a $1 NAV. This mandate encourages fund managers to make regular payments to investors, providing them with a steady stream of income. It also makes it simple to calculate and track the net gains generated by the fund.

Breaking the Buck

A money market fund’s NAV may occasionally go below $1. This results in a situation that is commonly referred to as “breaking the buck.” This situation can be linked to transitory price changes in the money markets when it happens. However, if the scenario persists, it may result in a situation in which the money market fund’s investment income does not equal its running expenditures or investment losses.

For example, if the fund utilized excessive leverage in acquiring instruments, or if overall interest rates fell to near-zero levels, and the fund lost money, one of these situations may result in the fund being unable to satisfy redemption demands. If this occurs, authorities may intervene and order the fund to liquidate. Breaking the buck, on the other hand, is extremely unusual.

The first incident of passing the buck occurred in 1994. At $0.96 per share, the Community Bankers U.S. Government Money Market Fund was liquidated. This was due to substantial losses experienced by the fund during a period of extensive investment in derivatives.

Following the failure of Lehman Brothers in 2008, the renowned Reserve Primary Fund also failed. The fund contained millions of dollars in Lehman Brothers debt obligations, and investor fear led its NAV to collapse to $0.97 per share. The Reserve Primary Fund was forced to liquidate as a result of the money withdrawal. The money markets were thrown into chaos as a result of this catastrophe.

To prevent this from happening again, the SEC adopted new regulations to properly manage money market funds in 2010, in the aftermath of the 2008 financial crisis. These regulations were designed to increase stability and resilience by tightening limitations on portfolio holdings and adding measures for charging liquidity fees and halting redemptions.

Regulation of Money Market Funds


In the U.S., money market funds are under the purview of the SEC. This regulatory body defines the necessary guidelines for the characteristics, maturity, and variety of allowable investments in a money market fund.

Under the provisions, a money fund mainly invests in the top-rated debt instruments, and they should have a maturity period under 13 months.4 The money market fund portfolio is required to maintain a weighted average maturity (WAM) period of 60 days or less. This WAM requirement means that the average maturity period of all the invested instruments—taken in proportion to their weights in the fund portfolio—should not be more than 60 days.5 This maturity limitation is done to ensure that only highly liquid instruments qualify for investments, and the investor’s money is not locked into long-maturity instruments that can mar the liquidity.

A money market fund is not allowed to invest more than 5% in any one issuer (in order to avoid issuer-specific risk).6 However, government-issued securities and repurchase agreements provide an exception to this rule.

Advantages and Disadvantages of Money Market Funds


Money market funds compete against similar investment options, such as bank money market accounts, ultrashort bond funds, and enhanced cash funds. These investment options may invest in a wider variety of assets, as well as aiming for higher returns.

The primary purpose of a money market fund is to provide investors a safe avenue for investing in secure and highly liquid, cash-equivalent, debt-based assets using smaller investment amounts. In the realm of mutual-fund-like investments, money market funds are characterized as low-risk, low-return investments.

Many investors prefer to park substantial amounts of cash in such funds for the short term. However, money market funds are not suitable for long-term investment goals, like retirement planning. This is because they don’t offer much capital appreciation.

Money market funds appear attractive to investors as they come with no loads—no entry charges or exit charges. Many funds also provide investors with tax-advantaged gains by investing in municipal securities that are tax-exempt at the federal tax level (and in some instances at the state level, too).

Pros

  • Very low-risk
  • Highly liquid
  • Better returns than bank accounts

Cons

  • Not FDIC-insured
  • No capital appreciation
  • Sensitive to interest rate fluctuations, monetary policy

It’s important to keep in mind that money market funds are not covered by the FDIC’s federal deposit insurance, while money market deposit accounts, online savings accounts, and certificates of deposit, are covered by this type of insurance. Like other investment securities, money market funds are regulated under the Investment Company Act of 1940.

An active investor who has time and knowledge to hunt around for the best possible short-term debt instruments—offering the best possible interest rates at their preferred levels of risk—may prefer investing on their own in the various available instruments. On the other hand, a less-savvy investor may prefer taking the money market fund route by delegating the money management task to the fund operators.

Fund shareholders can typically withdraw their money at any time, but they may have a limit on the number of times they can withdraw within a certain period.

History of Money Market Funds

Money market funds were designed and launched during the early 1970s in the U.S. They gained rapid popularity because they were an easy way for investors to purchase a pool of securities that, in general, offered better returns than those available from a standard interest-bearing bank account.

Commercial paper has become a common component of many money market funds. Previously, money market funds held only government bonds. However, this transition away from only government bonds resulted in higher yields. At the same time, it was this reliance on commercial paper that led to the Reserve Primary Fund crisis.

In addition to the reforms that the SEC introduced in 2010, the SEC also implemented some fundamental structural changes to the way they regulate money market funds in 2016.

These changes required prime institutional money market funds to float their NAV and no longer maintain a stable price. Retail and U.S. government money market funds were allowed to maintain the stable $1 per share policy. The regulations also provided non-government money market fund boards with new tools to address runs.

Money Market Funds Today

Today, money market funds have become one of the core pillars of the present-day capital markets. For investors, they offer a diversified, professionally-managed portfolio with high daily liquidity. Many investors use money market funds as a place to park their cash until they decide on other investments or for funding needs that may arise in the short-term.

The interest rates that are available on the various instruments that constitute the portfolio of a money market fund are the key factors that determine the return from a given money market fund. Looking at historical data is enough to provide sufficient details on how money market returns have fared.

During the decade spanning from 2000 to 2010, the monetary policies of the Federal Reserve Bank led to short-term interest rates—the rates banks pay to borrow money from one another—hovering around 0%. These near-zero rates meant money market fund investors saw returns that were significantly lower, compared to those in the prior decades. Further, with the tightening of regulations after the 2008 financial crisis, the number of investable securities grew smaller.

A 2012 comparative study by Winthrop Capital Management indicates that, although the net assets of the Federated Prime Money Market Fund increased from $95.7 billion to $204.1 billion between 2007 and 2011, the total return from the fund effectively fell from 4.78% to 0% during the same period.

Another economic policy in recent years that has had an adverse impact on money market funds is quantitative easing (QE). QE is an unconventional monetary policy where a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.

As major economies across the globe—including the U.S.—followed QE measures in the aftermaths of the 2008 financial crisis, a good portion of the QE money made its way into money market mutual funds as a haven. This migration of funds led to interest rates remaining low for a long duration, and the diminishing of returns from money market funds.

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