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What Are Money Market Funds? Defined & Explained

Written by Than Merrill

Money market funds (MMFs) are essentially mutual funds with rules stipulating what their respective money managers can and can’t invest in. Beyond that, however, mutual funds with an emphasis on cash assets have developed a reputation for preserving capital and providing dependable income for risk-averse investors. Nonetheless, the nature of their holdings is unique enough to warrant a look behind the curtain. Only those who know what money market funds are and how they work should even consider adding them to their own portfolios.

What Is A Money Market Fund?

A money market fund isn’t all that different from a traditional mutual fund. Whereas mutual funds are financial platforms which allow several investors to pool their money in order to invest in a number of securities (stocks, bonds, money market instruments, and other assets), money market funds do the same thing, only they focus specifically on short-term, highly liquid investments. Instead of the designated money manager investing whatever they feel like, they pay special considerations to cash, cash-equivalent securities, and short-term, debt-based securities with high credit ratings.

The cash-centric nature of a money market fund caters to risk-averse investors who would rather have a professional in charge of their money. If for nothing else, the money managers in charge of money market funds are tasked with prioritizing stable liquidity over volatile and leveraged assets.

How Does A Money Market Fund Work?

Investing in a money market fund is as simple as buying shares through the appropriate entity. Mutual fund companies, brokerages, and banks are the most common places investors choose to buy into a money market fund, but the popularization of online portals are making these financial vehicles more accessible to the general public. As a result, investors of every level can gain access to a money market fund through their phone.

Investing in money market funds is a relatively simple way to increase any investor’s net worth, which begs the question: How does a money market fund work?

If an investor is confident they want to buy into a money market fund, they first need to choose the right money manager. Not surprisingly, there are several money market funds to choose from, all with different investment strategies and benchmarks of their own. Therefore, investors must first look for the money market fund that suits their needs.

Once the candidates have been narrowed down and the appropriate benchmark has been identified, investors will proceed to invest in the money market fund of their choosing. Investors will then need to determine how much they want to invest, and at which rate. Contributors may choose to invest one lump sum or execute a systematic investment plan (SIP), which will have them put in smaller amounts over time; this allows investors with almost any sort of budget to pool their money.

Upon contributing to the money market fund, investors will receive units relative to the amount invested. Each unit dispersed by the money market fund simultaneously represents the money invested and how much respective investors will be payed out when the mutual fund returns profits.

The capital pooled together by the money manager will be invested in a diversified portfolio of debt-based financial instruments which include, but are not limited to:

  • Bankers’ Acceptances (BA)

  • Certificates Of Deposit (CDs)

  • Commercial Paper

  • Repurchase agreements (Repo)

  • U.S. Treasuries

The money market fund will use these vehicles to meet their own benchmark. However, applicable market interest rates will play a role in each investors’ return on investment (ROI). Since each instrument is dependent on interest rates, so too are investor returns.

If profits are realized, investors may choose to exchange their units and cash out or reinvest profits back into the fund and potentially compound earnings over years (if not decades).

However, it needs to be noted that investing in money market funds isn’t free. Investors will need to pay their fair share to have their money professionally managed. More specifically, money managers will take a percentage of the profits they make—somewhere in the neighborhood of 1.0% and 3.0%.

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What Is Net Asset Value (NAV)?

One thing separates traditional mutual funds from money market funds: net asset value (NAV). While most mutual funds seek to meet or exceed their benchmark, MMFs aim to maintain a net asset value of $1 per share. If the money market fund fails to meet the NAV standard of $1, investors will lose out on profits. In the event earnings generated through interest exceed more than $1 per share, however, excess capital will be distributed to investors in the form of dividend payments.

In trying to maintain the net asset value, money market fund managers must regularly make payments to investors. As a result, many investors have come to rely on money market funds for dependable income. That said, many consider cash-centric funds to be the mutual fund counterparts of dividend stocks; there isn’t always a lot of room for growth, but the income can be dependable.

What Is Breaking The Buck?

In a perfect world, money market fund managers would always be able to maintain the net asset value. Unfortunately, no investment is guaranteed, and money market funds are no exception; there is always the risk a fund will drop below the $1 benchmark. Otherwise known colloquially as “breaking the buck,” money market funds that don’t maintain the net asset value are at risk of losing money. Specifically, breaking the buck occurs when investment income fails to exceed operating expenses or investment losses. In either case, breaking the buck constantly spells bad news for funds and their respective pool of investors.

Types Of Money Market Funds

Not unlike traditional mutual funds, money market funds are dividend into several types based on the assets they hold:

  • Treasury Only: At least 95.5% of this type of fund’s assets need to be invested in cash and U.S. Treasury securities. Out of the 95.5% dedicated to cash and U.S. Treasury securities, 80.0% needs to be allocated to U.S. Treasury securities.

  • Treasury: At least 95.5% of this type of fund’s assets need to be invested in cash, U.S. Treasury securities and/or repurchase agreements using U.S. Treasury securities as collateral. Out of the 95.5% dedicated to cash, U.S. Treasury securities and/or collateralized repurchase agreements, 80.0% needs to be allocated to U.S. Treasury securities and repurchase agreements for those securities.

  • Government: At least 95.5% of this type of fund’s assets need to be invested in cash, government securities and/or repurchase agreements which use cash or government securities as collateral.

  • Prime (General Purpose): Prime money market funds are free to invest in any U.S. dollar-denominated investment vehicle defined in Rule 2a-7 of the Investment Company Act of 1940 of the U.S. Securities and Exchange Commission regulations. Acceptable investments include everything listed above, as well as commercial paper, CDs, corporate notes, and other wealth-building instruments.

  • National Municipal (Tax Exempt): At least 80.0% of this type of fund’s assets need to be invested in municipal securities who do not need to pay federal income tax on their interest.

  • State Municipal (Tax Exempt): At least 80.0% of this type of fund’s assets need to be invested in municipal securities who do not need to pay federal income tax and state personal income tax on their interest.

Money Market Fund Regulations

Similar to all of the securities and commodities traded on Wall Street, money market funds reside under the scrutiny of the U.S. Securities and Exchange Commission (SEC). As its name suggests, the SEC is an independent agency of the United States federal government tasked with preventing market manipulation. In doing so, the SEC sets the standards of the market and makes sure everyone abides by them. As part of their strict guidelines, the SEC will define how and what MMFs can invest in.

Under SEC guidelines, money market funds are required to invest primarily in highly rated debt instruments with a maturity period somewhere in the neighborhood of 13 months or less. While the SEC wants to see maturity periods under 13 months, money market funds must maintain a weighted average maturity (WAM) period of 60 days or less. In other words, the average maturity period of all the invested instruments—relative to the ratio they make up in a fund’s portfolio—shouldn’t exceed 60 days. The limited maturity timeline isn’t necessarily to limit investment ideas for each fund, but rather to facilitate liquidity. The fewer days an instrument has to mature, the more liquid the fund can be. Consequently, investors’ money isn’t locked up for long periods of time, enabling the fund to live up to its standards.

In addition to issuing strict maturity guidelines, the SEC won’t allow money market funds to invest more than 5.0% of their capital in a single instrument. Relatively low allocations will allow money market funds to diversify properly and mitigate risk. That said, there are a few exceptions: Money market funds may invest more than 5.0% of their capital in government-issued securities and repurchase agreements.

Money market fund regulations implemented by the SEC are put in place to protect investors. While the guidelines may appear to limit investment opportunities, they are simply put in place to maintain order. That way, prospective investors know exactly what they are getting into before investing a single dollar.

Advantages Of Money Market Funds

The advantages of money market funds include, but are not limited to:

  • Risk Mitigation: The nature of the investment vehicles money market funds are allowed to invest in are relatively risk-averse. That’s not to say there’s no risk at all, but rather that the types of funds aim for “secure” returns. Additionally, the percent each fund is allowed to allocate to a single instrument encourages highly diversified portfolios.

  • Liquidity: Investing in cash, cash-equivalent securities, and short-term, debt-based securities with high credit ratings means fund managers can cash out regularly. Short-term maturity periods simultaneously provide higher levels of liquidity and dependable income on a predictable schedule.

  • Reliable Returns: While money market funds aren’t synonymous with high returns, they are known for dependable income. The nature of the instruments increases the odds of receiving reliable returns which can outpace traditional bank accounts.

Disadvantages Of Money Market Funds

The disadvantages of money market funds include, but are not limited to:

  • No FDIC Insurance: While the Federal Deposit Insurance Corporation (FDIC) insures deposits in American depository institutions, it’s important to note that money market funds are not covered by the FDIC’s insurance policies.

  • Lack Of Capital Appreciation: Since maturity timelines are relatively short, money market fund investors do not benefit from capital appreciation. Instead, any cash that exceeds the net asset value benchmark is redistributed to investors in the form of dividends.

  • Exposure To External Factors: Since cash, cash-equivalent securities, and short-term, debt-based securities are sensitive to interest rate fluctuations and government policies, money market funds are exposed to a minimal level of inherent level risk. Investor returns can vary based on current government practices and the state of the economy.

How Are Money Market Funds Taxed?

Whether or not the profits derived from a money market fund are taxed will depend solely on the types of securities the fund holds. While the income generated from treasury, treasury only, government, and prime money market funds is generally taxable, their municipal counterparts aren’t. Consequently, income generated from national municipal and state municipal funds are generally tax-exempt. That said, many funds have diversified portfolios and it’s never safe to assume the taxable status. Instead, speak with the fund manager to determine whether or not the fund is taxed.

How Much Are Money Market Accounts Yielding?

Money market funds are not known for their high-growth potential, nor are they synonymous with high yields. Instead, MMFs serve one purpose: to preserve capital while providing investors with dependable income in the form of dividends. In doing so, money market funds yield somewhere in the neighborhood of 0.08% each month; that places money market fund yields squarely between checking account interest and one month certificate of deposit.

Summary

Wall Street comes complete with a variety of investment vehicles, not the least of which are designed to cater to every type of investor—from the risk averse who are on the brink of retirement to new investors with decades of opportunities on the horizon. That said, money market funds aren’t designed to take up entire portfolios, but are instead used to compliment diversified holdings. Many investors use them to hedge their bets or preserve capital in the twilight of their working years, but that doesn’t mean they couldn’t make a good addition to anyone’s portfolio.


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