Money Market Funds

What are Money Market Funds?

Money market funds are a type of mutual funds managed by an investment company that invests in short-term, low-risk securities. They hold a portfolio of securities, including cash, cash equivalent securities, and debt-based securities with short maturities and high credit ratings – including US Treasury bills and repurchase agreements (repos).

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They are designed to provide investors with a relatively safe and stable option for investing their cash while earning a modest return. They are considered to be an attractive choice for investors seeking liquidity and capital preservation, rather than high-risk capital appreciation.

Money market funds are not to be confused with money market accounts, which are a type of savings account that pays interest and is provided by financial institutions.

How Do Money Market Funds Work?

Money market funds invest in various short-term instruments such as Treasury securities, certificates of deposit (CDs), and commercial paper. They aim to maintain a stable net asset value (NAV) of $1 per share. This stability is achieved by investing in securities with short maturities and high credit quality.

Investors buy units in money market funds, meaning the fund manager allocates the pooled funds into a diversified portfolio of short-term securities. The interest earned from these investments is then distributed to the shareholders as dividends.

The income from money market funds can be taxable or tax-exempt, depending on the types of securities the fund holds. Investors can redeem their units in exchange for cash at any time, receiving same-day or next-day access to their funds.

Some money market funds aim to provide a constant net asset value of 1.00 in the currency they are sold, such as $1.00, allowing investors to receive all their returns as income.

Others float their NAV to the fourth decimal place, so they trade at the market value of the securities in the portfolio and can provide returns as both capital and income.

In the US, money market funds must comply with regulations set by the Securities and Exchange Commission (SEC) regarding the credit quality, maturity, liquidity, and diversification of their securities.

Regulations in other regions also require such funds to maintain sufficient liquidity to meet reasonable redemptions. They should typically invest at least 10% of the fund portfolio in securities that can provide daily liquidity and at least 30% in securities that can provide weekly liquidity.

As money market funds are investments rather than saving accounts, regulators do not provide guarantees of principal or insurance.

History of Money Market Funds

Money market funds were first introduced in the early 1970s as a new type of investment fund to provide investors with a low-risk alternative to traditional savings accounts. The concept gained popularity, and the best money market funds became a staple in the investment landscape, offering a balance of safety and yield.

The funds initially held government bonds, but later diversified to include commercial paper and other instruments, which increased yields. The reliance on commercial paper resulted in the Reserve Primary Fund crisis.

Following the 2008 financial crisis, the SEC introduced reforms in 2010 and structural changes in 2016 to the way money market funds are regulated.

The changes included requiring prime institutional money market funds to float their NAV rather than maintaining a stable price, and providing non-government fund managers with new tools to address runs, in which larger numbers of investors attempt to redeem their units at the same time.

Quantitative easing policies to purchase government securities and other instruments to keep interest rates low resulted in money flowing into money market funds, although their returns were low.

How to Invest in Money Market Funds

To invest in a money market fund, an individual can typically purchase shares directly from the fund company or through a brokerage account. The minimum investment requirements vary among funds, but they are generally accessible to a wide range of investors.

Types of Money Market Funds

There are different types of money market funds, catering to different investor needs.

Types of Money Market Funds

These include:

  • Government: Invest at least 99.5% of their total holdings in cash, government securities, and repos that are fully collateralized by cash or government securities.
  • Prime: Invest in non-Treasury debt securities, including those issued by corporations and government-sponsored enterprises.
  • Municipal: Hold short-term securities issued by states, local governments, and other municipal agencies. Returns are exempt from federal – and sometimes state – income taxes.
  • Treasury: Hold US Treasury-issued debt securities, such as bills, bonds, and notes.

Pros and Cons

There are pros and cons for investors looking to include money market funds in their portfolios.

Pros Cons
Stability and capital preservation. Returns are typically lower than riskier investments such as stocks.
High liquidity allows investors to access their funds quickly. Modest returns may not keep pace with inflation, eroding purchasing power.
Portfolio diversification. Not covered by the Federal Deposit Insurance Corporation (FDIC)
Higher returns than bank deposits and savings accounts. Lack of capital appreciation.
SEC regulations require funds to hold low-risk investments and diverse exposure across issuers. Sensitive to monetary policy, such as interest rate fluctuations.
Short duration makes funds less vulnerable to interest rate risk. Funds managed in foreign countries can be affected by political, regulatory, market, or economic developments.
Potential tax advantages. Not suitable for long-term investment.
No entry or exit charges. Changes in government regulations and economic conditions affect issuers’ ability to repay their debts, affecting fund value.

FAQs

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References

  1. SEC.gov | Money Market Funds (U.S. Securities and Exchange Comission)
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Nicole Willing

Nicole is a professional journalist with 20 years of experience in writing and editing. Her expertise spans both the tech and financial industries. She has developed expertise in covering commodity, equity, and cryptocurrency markets, as well as the latest trends across the technology sector, from semiconductors to electric vehicles. She holds a degree in Journalism from City University, London. Having embraced the digital nomad lifestyle, she can usually be found on the beach brushing sand out of her keyboard in between snorkeling trips.