What is a Money Market Fund
A money market fund is a kind of mutual fund which invests only in highly liquid cash and cash equivalent securities that have high credit ratings. Also called a money market mutual fund, these funds invest primarily in debt-based securities which have a short-term maturity of less than 13 months, and offer high liquidity with very low level of risk. Working on the lines of a standard mutual fund, money market funds issue redeemable units (also called shares) to investors, and are mandated to follow the guidelines drafted by the local regulators, like those set by the Securities and Exchange Commission (SEC) in the U.S.
BREAKING DOWN Money Market Fund
While all features of a standard mutual fund apply to a money market fund, there is one key difference. A money market fund aims to maintain a net asset value (NAV) of $1 per share. Any excess earnings that get generated by the way of interest received on the portfolio holdings are distributed to the investors in the form of dividend payments. Investors can purchase/redeem shares of money market funds through mutual funds, brokerage firms and banks.
One of the primary reasons for the popularity of money market funds is their requirement to maintain the $1 NAV. It forces the fund managers to make regular payments to the fund investors which acts as a regular flow of income for the investors. It also allows easy calculations and tracking of the net gains generated from the fund.
While there was a proposal by SEC around 2012 to move from the fixed $1 NAV model to a floating NAV model for the money market funds, the agency was forced to withdraw the proposal as it could not garner the necessary support from the industry and from other involved entities. Beyond structural changes, the proposal would have put the working model of the money market funds at a big risk, as investors could have found alternative avenues to park their cash thereby dismantling one of the key pillars of the capital markets.
Breaking the Buck
Occasionally, a money market fund may fall below the $1 NAV, a condition which is described by the term breaking the buck. The situation occurs when the investment income of a money market fund fails to exceed its operating expenses or investment losses (if any). This is possible if the fund has used excess leverage that leads to capital risk in otherwise risk-free instruments, or when the overall interest rates have dropped to very low levels nearing zero.
Regulators jump in when a money market mutual fund breaks the buck, and forces its liquidation. Year 1994 saw the first instance of a money market fund breaking the buck, when Community Bankers U.S. Government Money Market Fund was liquidated at 96 cents owing to the large losses it incurred in derivatives. Following the 2008 financial crisis that led to the bankruptcy of Lehman Brothers, the Reserve Fund broke the buck when its NAV fell to 97 cents per share amid heightened fears of exposure to Lehman’s papers. The pullout of money from the Reserve Fund by the concerned investors trigged the money market mayhem.
However, there have been only a handful of cases of breaking the buck. To avoid any similar future occurrences, SEC issued new rules after the 2008 crisis to better manage money market funds and provide more stability and resilience. The new rules placed tighter restrictions on portfolio holdings and introduced provisions for imposing liquidity fees and suspending redemptions.
Investment Options for a Money Market Fund
A money market fund may invest in the following types of debt based financial instruments:
Returns from these instruments are dependent on the applicable interest rates, and therefore the overall returns from the money market funds are also dependent on the interest rates.
Types of Money Market Funds
Money market funds are classified into various types depending upon the class of invested assets, maturity period, and other attributes.
- A Prime money fund invests in floating-rate debt and commercial paper of non-treasury assets, like those issued by corporations and securities of the US government and agencies.
- A Government money fund invests at least 99.5 percent of its total assets in cash, government securities, and/or repurchase agreements that are fully collateralized by cash or government securities.
- A Treasury fund is a type of government money fund that invests in standard U.S. treasury issued debt securities which include US Treasury Bills, Bonds and Notes.
- A Tax-exempt money fund offers exemption from U.S. federal income tax to the fund investors, and also exemption to full/certain extent from the state income taxes. Municipal debt securities primarily constitute such types of money market funds.
- Depending upon the target client base, Institutional money fund which are targeted to attract institutional money with high minimum investment amount, and Retail money fund which are offered to individual investors with small investment amount, are also popular.
Evolution of Money Market Funds
Money market funds were designed and launched during the early 1970s in the U.S. They gained rapid popularity as an easy medium for investors to purchase a pool of securities which generally offered better returns than those available from a standard interest-bearing bank account. Many investors use money market funds for managing their cash and for other funding needs that may arise in the short term.
SEC reports that the popularity and investments in money market funds has grown significantly and they currently hold about $3.0 trillion in assets. They have become one of the core pillars of the present-day capital markets as they offer investors a diversified, professionally managed portfolio with high daily liquidity.
Regulations of Money Market Funds
In the U.S., the money market funds are under the purview of SEC which defines the necessary guidelines for the characteristics, maturity and variety of the instruments in which a money market fund can invest in.
Under the provisions, a money fund mainly invests in the top rated debt instruments, and they should have maturity period under 13 months. The money market fund portfolio is required to maintain a weighted average maturity (WAM) period of 60 days or less – which means that the average maturity period of all the invested instruments taken in proportion of their weights in the fund portfolio should not be more than 60 days. This is done to ensure that only highly liquid instruments qualify for investments, and investor’s money is not locked-in long maturity instruments that can mar the liquidity.
A money market fund is not allowed to invest more than 5 percent in any one issuer to avoid issuer specific risk. However, government issued securities and repurchase agreements are exempted from this 5 percent limit as they are considered risk-free.
Factors Affecting Returns from Money Market Funds
The interest rates available on the various instruments constituting the portfolio are the key factors that determine the return from the money market funds. Historical instances provide sufficient details on how money market returns have fared.
Since the monetary policies of the Federal Reserve Bank during the last decade have led to the short term interest rates hovering around zero percent, the return from the money market mutual fund investors have been significantly lower compared to those in the prior decades. Additionally, the tightening of regulations in the aftermaths of the financial crisis of 2008 has led to the universe of investable securities getting smaller. A comparative study by Winthrop Capital Management indicates that though the net assets of the Federated Prime Money Market Fund increased from $95.70 billion to $204.10 billion from 2007 to 2011, the total return from the fund effectively reduced from 4.78 percent to zero percent during the same period.
Quantitative easing (QE), an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply, has had an adverse effect on money market funds. As major economies across the globe (including the U.S.) went for QE measures in the aftermaths of the financial crisis of 2008, a good portion of the QE money made its way into money market mutual funds as a safe haven. This has led to interest rates remaining low for a long duration, and returns from money market funds getting diminished.
Money Market Funds as Investment
Money market funds compete against similar investment options like money market accounts, ultrashort bond funds, and enhanced cash funds which may invest in a wider variety of assets and aim for higher retuns.
The primary purpose of a money market fund is to provide investors a safe medium through which they can invest in easily accessible, secure, and highly liquid cash-equivalent debt-based assets using smaller investment amounts. It is a type of mutual fund characterized as a low-risk, low-return investment. Owing to the low returns, investors may prefer parking their money for short term in such funds. However, such funds are not suitable for long term investments, like investing for retirement planning, as they don’t offer the expected capital appreciation required to meet the long term financial goals.
Money market funds appear attractive to investors as they come with no load (entry/exit charges). Many funds also provide investors with tax-advantaged gains by investing in municipal securities that are tax-exempt at the federal and/or state level.
However, these funds are not covered by federal deposit insurance, while other comparable investment options, like money market deposit accounts, online savings accounts and certificates of deposit, are covered. Money market funds are considered safe investments and 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 his preferred levels of risk may prefer investing on his own in the various available instruments. Money market accounts appeal to investors and savers because they can shop around to find banks that pay higher interest rates, and banks will often offer higher rates for larger balances.
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. Those using a money market fund can typically withdraw their money at any time but may have a limit on the number of times they can withdraw.