What is a Money Market Fund?

These funds are designed to be an easy, safe, and short-term way to make your cash work for you in a diversified way, rather than let it sit idle in your bank account. Their function is to preserve your capital, generate a modest income through interest, and allow you to access your money whenever you need it.

How money market funds work

Regulations are stricter for MMFs than for other mutual funds. Since they function as a kind of cash investment, they’re regulated to make sure that they remain stable and liquid. Regulation and credit quality also ensure your cash is preserved and doesn’t lose value.

MMFs make large investments in short-term instruments. Cash equivalents are extremely liquid and can be converted to cash at any time. They typically take three months or less to mature. Short-term debt securities are less liquid and take longer to mature, usually under a year. They are used for short-term borrowing and lending and are considered high-quality because there is a very low risk that they default on their payments. This also serves to minimize the effects of volatility and preserve your capital.

Regulation also requires these funds to hold a certain percentage of assets in liquidity that can be redeemed daily, like cash, and a certain percentage in instruments that can provide weekly liquidity. These funds have to maintain a certain level of liquidity in order to have cash to return to investors who want to take their money out of the fund to use elsewhere. You can generally take your money out the same day or the next day, depending on the fund.

They use special accounting techniques to achieve this. The income investors earn from the fund, therefore, comes in the form of a dividend.

Every day, the fund will add your earned interest to your balance. At the end of each month, you can either have that interest dividend reinvested into more shares or choose to have it paid to you directly in cash. Costs and fees associated with running the fund are already taken into account when you receive yields or buy or sell shares, so what you see is what you get.

Types of money market funds

Money market funds are regulated differently depending on the region they are located in, but in general, there are four main types.

• Government MMFs, as their name suggests, invest in government debt and repurchase agreements backed by government securities, in addition to holding cash. These are very low-risk funds and ideal for more conservative investors who are looking for stability and liquidity.

• Short-term credit MMFs, or prime MMFs, invest in non-government securities like bank debt and corporate debt, in addition to government securities and holding cash. These funds are slightly riskier but offer higher returns.

• Municipal MMFs invest in municipal bonds issued by state and local governments. These funds usually offer tax benefits to investors because their earnings are often exempt from federal and state taxes.

• Standard MMFs are focused on generating higher yields. They do so by holding investors longer than other funds (usually with a minimum investment period of three months), holding less liquidity, and having lower credit quality. This also means they are riskier than the other types.

Advantages of money market funds

Bank accounts, fixed deposits (FD), and certificates of deposit (CD) also allow you to generate interest on cash, and they are guaranteed, so why not invest in one of those instead? Here are a few reasons to invest in them:

Diversity

MMFs invest in many instruments, including FDs and CDs, so you are getting more bang for your buck. They offer a kind of diversity that you wouldn’t have access to if you were to park your cash in a normal savings account. You also avoid being overexposed or concentrating too much of your money in a single bank, because a fund’s investments are spread out over several issuers.

Low risk

They are much safer than investing in stocks, bonds, or mutual funds that invest in those kinds of assets. They are designed to be this way and regulated to stay that way.

Operational ease

They are easy to invest in: you simply buy or sell shares of the fund, and the rest is managed on your behalf. You can achieve diversification with a single share. It would be more complicated and time-consuming to do so on your own because you would have to continuously reinvest your money after reaching short-term maturity. With MMFs, your money remains invested as long as you own the shares.

Higher yield

Thanks to the fund pooling money, you can have access to several securities using less capital. Your return is simply proportional to the amount you invest. Since funds are actively managed and invest in short-term positions, they tend to generate earnings that are greater than those of a deposit or savings account. Putting your cash in an MMF is therefore kind of like holding your cash on steroids.

Liquidity

Unlike traditional interest-earning bank accounts, MMFs don’t have any lock-up periods, which means they won’t impose penalties if you take your money back before a certain date. You just redeem your initial investment with whatever interest the fund has generated in that time. This liquidity makes MMFs more attractive and grants investors greater freedom.

Limitations of money market funds

While MMFs have their advantages, they also have their own set of limitations.

No guarantee or insurance

There is absolutely no guarantee that the MMF will generate any interest for you, and you run the risk of losing your investment if the fund goes bankrupt. Your money isn’t protected like it would be in an FDIC-insured deposit or savings account. Once again, higher rewards come with higher risk.

Low returns

While MMFs will generate more money than holding cash or putting it in a savings account, their returns are still very low compared to other types of mutual funds or investments. If interest rates are lowered, the funds will also generate lower returns. Some funds may be better equipped to make up for changes in interest rates than others.

Low interest rate

If interest rates are lower than inflation, keeping your money in the fund equates to losing money. The amount you receive in interest is too low to keep up with inflation, so your purchasing power goes down. You could say that any interest earned is better than no interest earned, but you can also put your money to work elsewhere. Funds mostly tend to outperform inflation, though, and even when inflation rises too high, rates are adjusted and inflation eventually comes back down, so it doesn’t last too long.

Credit risk

If a bank borrowing money from the fund goes bankrupt, it can’t pay it back to the fund, and investors can lose money. MMFs tend to invest only in the biggest and most established and reliable banks, so while it is still a possibility, losing money like this is very rare.

Market stress

In very rare cases, when the market is under a great amount of stress, the NAV price can “break the buck” and drop below $1. MMFs are highly regulated to avoid this, but it remains a rare possibility. During a financial crisis, funds can also impose fees to limit redemptions. If things get really bad, funds can also block investors from redeeming their money altogether until things settle down. This is called a “redemption gate.”

Summing up

Always do your research and read up on the fund you want to invest in, because some funds may be better equipped to deal with market volatility, geopolitical events, lowered interest rates, and general uncertainty. MMFs will have an online prospectus on their website that details their strategy, assets, performance, fees, and other important information, allowing you to make informed decisions. You can also find this information on the SEC’s website.