A money market fund is a type of mutual fund that invests in highly liquid, near-term instruments. These instruments include cash, cash equivalent securities, and high-credit-rating, debt-based securities with a short-term maturity, such as U.S. Treasuries. Money market funds aim to offer investors high liquidity with a very low level of risk and are also known as money market mutual funds.
Though they share a similar name, a money market fund is not the same as a money market account (MMA). A money market account is an interest-earning savings account offered by financial institutions and insured by the Federal Deposit Insurance Corporation (FDIC). In contrast, a money market fund is an investment product that carries no guarantee of principal and is managed by an investment fund company.
Key Takeaways
- A money market fund is a mutual fund that invests in high-quality, short-term debt instruments, cash, and cash equivalents.
- Though not as safe as cash, money market funds are considered extremely low-risk on the investment spectrum.
- A money market fund generates income (taxable or tax-free, depending on its portfolio), but offers little capital appreciation.
- Money market funds should be used to park money temporarily before investing elsewhere or for anticipated cash needs. They are not suitable as long-term investments.
How a Money Market Fund Works
Money market funds work like typical mutual funds. They issue redeemable units or shares to investors and are mandated to follow guidelines drafted by financial regulators, such as the U.S. Securities and Exchange Commission (SEC).
A money market fund may invest in the following types of debt-based financial instruments:
- Bankers’ Acceptances (BA) – short-term debt guaranteed by a commercial bank.
- Certificates of Deposit (CDs) – bank-issued savings certificates 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.
The returns from these instruments depend on prevailing market interest rates, which subsequently influence the overall returns of the money market fund.
Types of Money Market Funds
Money market funds are categorized into various types based on the class of invested assets, maturity periods, and other attributes. Here are the primary types:
Prime Money Fund
A prime money fund invests in floating-rate debt and commercial paper of non-Treasury assets, such as those issued by corporations, U.S. government agencies, and government-sponsored enterprises (GSEs).
Government Money Fund
A government money fund invests at least 99.5% of its total assets in cash, government securities, and repurchase agreements fully collateralized by cash or government securities.
Treasury Fund
A Treasury fund invests in standard U.S. Treasury-issued debt securities, such as Treasury bills, Treasury bonds, and Treasury notes.
Tax-Exempt Money Fund
A tax-exempt money fund provides earnings that are free from U.S. federal income tax. Depending on the specific securities it invests in, the fund may also be exempt from state income taxes. This category primarily includes municipal bonds and debt securities.
Special Considerations
The Net Asset Value (NAV) Standard
A money market fund aims to maintain a NAV of $1 per share. Any excess earnings generated through interest from the portfolio holdings are distributed to investors via dividends. Investors can purchase or redeem shares of money market funds through fund companies, brokerage firms, and banks.
One of the key factors contributing to the popularity of money market funds is their $1 NAV maintenance, providing regular income to investors and allowing easy tracking of net gains.
Breaking the Buck
Occasionally, a money market fund may fall below the $1 NAV, an event sometimes referred to as ‘breaking the buck.’ This can be due to temporary price fluctuations in the money markets. Persistent conditions causing this scenario might force a fund liquidation overseen by regulators. However, such events are rare.
For instance, in 1994, the Community Bankers U.S. Government Money Market Fund was liquidated at $0.96 per share due to losses from heavy investment in derivatives. The 2008 financial crisis also saw the Reserve Primary Fund break the buck, leading to liquidation following the Lehman Brothers bankruptcy.
To mitigate recurrence, the SEC introduced new rules in 2010 to better manage money market funds, provide stability, and allow for liquidity fees and redemption suspensions.
Regulation of Money Market Funds
In the U.S., the SEC oversees money market funds, defining guidelines for characteristics, maturity, and investment diversity. Funds typically invest in top-rated debt instruments with a maturity period under 13 months and maintain a weighted average maturity (WAM) of 60 days or less. This ensures funds remain highly liquid, mitigating long-maturity instrument risks.
A money market fund is restricted from investing more than 5% in any one issuer to avoid issuer-specific risk, with exceptions for government-issued securities and repurchase agreements.
Advantages and Disadvantages of Money Market Funds
Money market funds offer a safe avenue for investing in secure, highly liquid, and cash-equivalent debt-based assets with smaller investment quantities. They are characterized as low-risk, low-return investments, making them ideal for parking cash temporarily.
Pros
- Very low-risk.
- Highly liquid.
- Better returns than bank accounts.
Cons
- Not FDIC-insured.
- No capital appreciation.
- Sensitive to interest rate fluctuations and monetary policy.
It’s essential to note that money market funds are not FDIC-insured, unlike money market deposit accounts, online savings accounts, and certificates of deposit. Regulated under the Investment Company Act of 1940, they provide options for passive investors to delegate money management to fund operators.
History of Money Market Funds
Money market funds were created in the early 1970s in the U.S., becoming popular due to better returns compared to standard bank accounts. Initially holding government bonds, the reliance on commercial paper evolved, resulting in higher yields but also contributing to the Reserve Primary Fund crisis.
Post-2008 financial crisis regulations (SEC 2010 reforms) enforced structural changes, such as NAV adjustment policies and enhanced board tools for non-government money market funds. These changes aimed to provide increased market stability and investor protection.
Money Market Funds Today
Currently, money market funds are a critical component of present-day capital markets, offering a diversified, professionally-managed portfolio with high daily liquidity. They serve as a safe haven for parking cash short-term and for meeting immediate funding requirements. The instruments’ interest rates largely dictate fund returns, making historical data crucial in analyzing performance.
Economic Impact
Policies like quantitative easing have had an adverse impact, contributing excess cash to money market funds, resulting in low interest rates and diminished returns. Over the last few decades, especially between 2000-2010, low short-term interest rates implemented by the Federal Reserve led to noticeably lower returns for investors.
Are Money Market Funds Safe?
Generally, money market funds are among the safest of all investments with a target value of $1 per share. They have only broker the buck during financial crises and usually recover quickly.
What Was the First Money Market Fund?
The first money market mutual fund appeared in 1971, known as ‘The Reserve Fund.’
Is a Money Market Account the Same as a Money Market Fund?
No, a money market fund is a mutual fund holding short-term treasuries and other money market instruments, while a money market account is a bank product crediting depositors a rate of interest.
The Bottom Line
Money market funds are a type of mutual fund investing in low-risk, short-term debt instruments like U.S. Treasuries, commercial papers, and CDs. Offering high liquidity and very low risk, money market funds are suitable for short-term liquidity needs, providing modest income through interest while maintaining a NAV of $1 per share. They remain sensitive to interest rate fluctuations, with regulatory enhancements ensuring better market stability and investor protection post-2008 crisis.
Today, money market funds are a key part of capital markets, presenting a viable investment option for both institutional and individual investors seeking a safe and liquid asset.
Related Terms: mutual funds, money market, investment accounts, commercial paper, U.S. Treasuries, NAV.
References
- U.S. Securities and Exchange Commission. “2014 Money Market Fund Reform Frequently Asked Questions”.
- TreasuryDirect. “Treasury Securities & Programs”.
- U.S. Securities and Exchange Commission. “What Are Municipal Bonds”.
- U.S. Securities and Exchange Commission. “Money Market Fund”.
- Investment Company Institute. “Re: IOSeO Money Market Fund Systemic Risk Analysis and Reform Options”, Page 5.
- U.S. Securities and Exchange Commission. “ECF Case 09 Civ. 4346 (PGG) Memorandum Opinion”, Page 8.
- U.S. Securities and Exchange Commission. “SEC Approves Money Market Fund Reforms to Better Protect Investors”.
- U.S. Securities and Exchange Commission. “Staff Responses to Questions About Money Market Fund Reform”.
- U.S. Securities and Exchange Commission. “SEC Adopts Money Market Fund Reform Rules”.
- Federal Deposit Insurance Corporation. “Are My Deposit Accounts Insured by the FDIC?”
- U.S. Securities and Exchange Commission. “Money Market Funds”.
- Matthew P. Fink. The rise of mutual funds: an insider’s view. Oxford University Press USA, 2011.
