Money Market Funds What They Are How They Work Pros and Cons
Money Market Funds: What They Are, How They Work, Pros and Cons
A money market fund is a mutual fund that invests in liquid instruments, including cash, cash equivalent securities, and high-credit-rating, debt-based securities with short-term maturity. Money market funds provide high liquidity and low-risk to investors. They are also known as money market mutual funds.
While similar in name, a money market fund is different from a money market account. A money market fund is an investment sponsored by an investment fund company and does not guarantee principal. A money market account is an interest-earning savings account insured by the FDIC with limited transaction privileges.
Key Takeaways:
– A money market fund invests in high-quality, short-term debt instruments, cash, and cash equivalents.
– Money market funds are low-risk investments.
– Money market funds generate income but do not have significant capital appreciation.
– Money market funds should be used for temporary parking of funds, not as long-term investments.
How a Money Market Fund Works
Money market funds function like typical mutual funds. They issue redeemable shares to investors and follow regulatory guidelines set by agencies like the SEC.
Money market funds may invest in various debt-based financial instruments, such as bankers’ acceptances, certificates of deposit, commercial paper, repurchase agreements, and U.S. Treasuries. Returns from these instruments depend on market interest rates.
Types of Money Market Funds
Money market funds are classified based on invested assets, maturity period, and other attributes.
– Prime Money Fund: Invests in non-Treasury debt and commercial paper.
– Government Money Fund: Invests primarily in cash, government securities, and fully collateralized repurchase agreements.
– Treasury Fund: Invests in U.S. Treasury-issued debt securities.
– Tax-Exempt Money Fund: Offers tax-exempt earnings from municipal bonds and other debt securities.
Considerations and Regulation
A money market fund aims to maintain a net asset value (NAV) of $1 per share. "Breaking the buck" occurs when a money market fund falls below this NAV due to price fluctuations or investment losses. Breaking the buck is rare but can lead to fund liquidation.
Money market funds fall under SEC regulation. They invest in top-rated debt instruments with maturity periods of 13 months or less. Weighted average maturity (WAM) must be 60 days or less to ensure high liquidity. Money market funds have limitations on issuer exposure, except for government-issued securities and repurchase agreements.
Advantages and Disadvantages of Money Market Funds
Advantages:
– Very low-risk
– Highly liquid
– Better returns than bank accounts
Disadvantages:
– Not FDIC-insured
– No capital appreciation
– Sensitive to interest rate fluctuations and monetary policy
Money market funds are not covered by FDIC insurance but are regulated under the Investment Company Act of 1940. Active investors may prefer investing individually, while others delegate money management to fund operators. Withdrawals from money market funds may have limits on the number of times within a specific period.
History of Money Market Funds
Money market funds gained popularity in the 1970s as a safe alternative to bank accounts. They focused on government bonds and later transitioned to include commercial paper for higher yields. Structural changes were implemented in 2016 to manage runs and maintain price stability.
Money Market Funds Today
Money market funds remain important in capital markets, offering diversification, professional management, and high liquidity. They are commonly used to park cash temporarily or for short-term funding needs. Returns depend on the interest rates of the invested instruments.
Recent economic policies like quantitative easing have impacted money market funds by lowering interest rates, reducing returns. Nonetheless, money market funds are considered safe with a target value of $1 per share.
The First Money Market Fund and Money Market Accounts
"The Reserve Fund" was the first money market mutual fund in 1971. Money market accounts differ from money market funds as bank products offering interest to depositors.
The Bottom Line
Money market funds are mutual fund investments that prioritize low-risk, short-term debt instruments. They offer high liquidity and stability, making them suitable for short-term investments. Money market funds aim to maintain a stable NAV of $1 per share but can experience breaking the buck. Regulation and structural changes ensure market stability and protect investors. Despite lower returns and fluctuating interest rates, money market funds remain an important part of the capital market for institutional and individual investors.
