What Is a Money Market Fund?

A money market fund is a kind of mutual fund that invests only in highly liquid instruments such as cash, cash equivalent securities, and high credit rating debt-based securities with a short-term, maturity—less than 13 months. As a result, these funds offer high liquidity with a very low level of risk.

While they sound highly similar, a money market fund is not the same as a money market account (MMA). The former is an investment, sponsored by an investment fund company, and hence carries no guarantee of principal. The latter is an interest-earning saving account offered by financial institutions, with limited transaction privileges and insured by the Federal Deposit Insurance Corporation (FDIC).

How a Money Market Fund Works

Also called money market mutual funds, money market funds work like any mutual fund. They issue redeemable units or shares to investors and are mandated to follow the guidelines drafted by financial regulators, like those set by the U.S. Securities and Exchange Commission (SEC).

A money market fund may invest in the following types of debt-based financial instruments:

Returns from these instruments are dependent on the applicable market interest rates, and therefore the overall returns from the money market funds are also dependent on interest rates.

Key Takeaways

  • A money market fund is a type of mutual fund that invests in high-quality, short-term debt instruments, cash, and cash equivalents.
  • Though not quite 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 little capital appreciation.
  • Money market funds should be used as a place to park money temporarily before investing elsewhere or making an anticipated cash outlay; they are not suitable as long-term investments.

Types of Money Market Funds

Money market funds are classified into various types depending upon the class of invested assets, the 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, U.S. government agencies, and government-sponsored enterprises (GSEs).
  • A Government money fund invests at least 99.5% of its total assets in cash, government securities, and repurchase agreements that are fully collateralized by cash or government securities.
  • A Treasury fund invests in standard U.S. Treasury issued debt securities such as bills, bonds, and notes.
  • A Tax-exempt money fund offers earnings that are free from U.S. federal income tax. Depending on the exact securities it invests in they may also have an exemption from state income taxes. Municipal bonds and other debt securities primarily constitute such types of money market funds.

Some money market funds are targeted to attract institutional money with a high minimum investment amount, often $1 million. Still, other money market funds are retail money funds, offered to individual investors via their small minimums.

The NAV Standard

All the features of a standard mutual fund apply to a money market fund, with 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 through interest on the portfolio holdings are distributed to the investors in the form of dividend payments. Investors can purchase or redeem shares of money market funds through investment fund companies, brokerage firms, and banks.

One of the primary reasons for the popularity of money market funds is their maintenance of the $1 NAV. This requirement forces the fund managers to make regular payments to investors, providing a regular flow of income for them. It also allows easy calculations and tracking of the net gains the fund generates.

Breaking the Buck

Occasionally, a money market fund may fall below the $1 NAV, and a condition colloquially called breaking the buck. The situation occurs when the investment income of a money market fund fails to exceed its operating expenses or investment losses.

Say the fund used excess leverage in purchasing instruments, or overall interest rates dropped to very low levels nearing zero. In these scenarios, the fund cannot meet redemption requests. When that happens, regulators jump in and forces its liquidation.

Breaking the buck rarely occurs. The year 1994 saw the first instance of it when Community Bankers U.S. Government Money Market Fund was liquidated at 96 cents per share, owing to the large losses it incurred by investing heavily in derivatives.

In 2008, following the bankruptcy of Lehman Brothers, the venerable Reserve Primary Fund broke the buck: It held millions of Lehman's debt obligations, and panicked redemptions by its investors caused its NAV to fall to 97 cents per share. The pullout of money caused the Reserve Primary Fund to close and triggered mayhem throughout the money markets.

To avoid any similar future occurrences, the 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.

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 way for investors to purchase a pool of securities which generally offered better returns than those available from a standard interest-bearing bank account.

Commercial paper has become a common component of money markets funds as they have evolved from holding only government bonds—their original mainstay—to boost yields. However, it was this reliance on commercial paper that led to the Reserve Primary Fund crisis. In addition to the post-financial crisis reforms in 2010, mentioned above, the SEC adopted fundamental structural changes to the regulations of money market funds. 

These changes require prime institutional money market funds to “float their NAV” and no longer maintain a stable price. The regulations also provide non-government money market fund boards with new tools to address runs. Retail and U.S. government money market funds were allowed to maintain the stable $1 per share policy. These reforms took effect in 2016.

The SEC reports that the popularity of and investments in money market funds has grown significantly and they currently hold about US$3 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. 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.

Pros of Money Market Funds

Money market funds compete against similar investment options like bank money market accounts, ultrashort bond funds, and enhanced cash funds which may invest in a wider variety of assets and aim for higher returns.

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 returns, investors may prefer parking 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, as they don’t offer much capital appreciation.

Money market funds appear attractive to investors as they come with no loads—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, the state level.

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

Cons of Money Market Funds

However, these funds are not covered by the FDIC's federal deposit insurance, while money market deposit accounts, online savings accounts, and certificates of deposit, are. 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 may have a limit on the number of times they can withdraw within a certain period.

Regulations of Money Market Funds

In the U.S., the 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. 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. This maturity limitation is done to ensure that only highly liquid instruments qualify for investments, and the 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% in any one issuer to avoid issuer-specific risk. Government-issued securities and repurchase agreements provide an exception to this rule.

Example of a Money Market Fund

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.

The monetary policies of the Federal Reserve Bank during the 2010s led to the short-term interest rates—the rates banks pay to borrow money from one another—hovering around zero percent. The near zero rates meant money market fund investors saw returns 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 though the net assets of the Federated Prime Money Market Fund increased from US$95.70 billion to $204.10 billion between 2007 and 2011, the total return from the fund effectively reduced from 4.78% to 0% during the same period.

Another adverse policy effect can be seen with the results of quantitative easing (QE). QE is an unconventional monetary policy where a central bank purchases government securities or other securities from the market 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 has led to interest rates remaining low for a long duration, and the diminishing of returns from money market funds. (For related reading, see "CPFXX, SPAXX, VMFXX: Top Government Money Market Funds")