What Is a Money Market Fund?
A money market fund is a kind of mutual fund that invests in highly liquid, near-term instruments. These instruments include:
- Cash
- Cash equivalent securities
- High-credit-rating, debt-based securities with a short-term maturity, such as United States Treasuries
Money market funds are intended to offer investors high liquidity with a very low level of risk. They’re also called money market mutual funds and are insured by the Securities Investor Protection Corporation (SIPC).
How a Money Market Fund Works
Money market funds work like a typical mutual fund. They issue redeemable units or shares to investors and are mandated to follow the guidelines drafted by financial regulators, such as those set by the U.S. Securities and Exchange Commission (SEC). Fund shareholders can typically withdraw their money at any time, but there may be a limit to the number of withdrawals during a certain period.
A money market fund may invest in the following types of debt-based financial instruments:
- Bankers’ Acceptances (BA): Short-term debts guaranteed by a commercial bank
- Certificates of deposit (CDs): Bank-issued savings certificates with short-term maturity
- Commercial paper: Unsecured short-term corporate debts
- Repurchase agreements (repo): Short-term government securities
- U.S. Treasuries: Short-term government debt issues
Returns from these instruments are dependent on the applicable market interest rates. The overall returns from the money market funds are therefore also dependent on interest rates.
An active investor who has the time and knowledge to hunt for the best possible short-term debt instruments, those offering the best possible interest rates at their preferred levels of risk, may decide to invest on their own in the various available instruments. A less-savvy investor or one with less free time may prefer taking the money market fund route and delegating the money management task to the fund operators.
Money market funds compete against similar investment options, such as bank money market accounts (MMAs), ultrashort bond funds, and enhanced cash funds. These investment options may include investing in a wider variety of assets and aiming for higher returns.
The Net Asset Value (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 generated through interest on the portfolio holdings are distributed to the investors as dividends. Investors can purchase or redeem money market fund shares through investment fund companies, brokerage firms, and banks.
Money market funds are popular because of 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.4 It also allows easy calculations and tracking of the net gains the fund generates.
Breaking the Buck
A money market fund may occasionally fall below the $1 NAV. This creates a condition that’s sometimes referred to with the colloquial term “breaking the buck.” This condition may be attributed to temporary price fluctuations in the money markets. The condition may trigger a moment when the investment income of the money market fund fails to exceed its operating expenses or investment losses, however, if it persists.
If the fund used excess leverage in purchasing instruments or if overall interest rates dropped to very low levels nearing zero, the fund broke the buck. One of these scenarios could lead to a condition where the fund cannot meet redemption requests. Regulators may jump in and force the fund’s liquidation if this happens. Instances of breaking the buck are very rare, however.
The first instance of breaking the buck occurred in 1994. The Community Bankers U.S. Government Money Market Fund was liquidated at $0.96 per share. This was the result of large losses that the fund incurred following a period of heavy investment in derivatives.
The Reserve Primary Fund also broke the buck following the 2008 bankruptcy of Lehman Brothers. The fund held millions of the Lehman Brothers debt obligations, and panicked redemptions by its investors caused its NAV to fall to $0.97 per share. This caused the fund to liquidate, triggering mayhem throughout the money markets.
The SEC issued new rules in 2010 to better manage money market funds and to prevent this from happening again. These rules were intended to provide more stability and resilience by placing tighter restrictions on portfolio holdings. They introduced provisions for imposing liquidity fees and suspending redemptions.
The SEC issued more reforms in 2023 in response to investors removing capital from their money market funds during the 2020 COVID-19 pandemic.
Types of Money Market Funds
Money market funds are classified into various types depending on the class of invested assets, the maturity period, and other attributes.
Prime Money Fund
A prime money fund invests in floating-rate debt and commercial paper of non-Treasury assets. These may be issued by corporations, U.S. government agencies, and government-sponsored enterprises (GSEs).
Government Money Fund
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. Treasury funds are also included in government money funds, which invest in standard U.S. Treasury-issued debt securities, such as Treasury bills, Treasury bonds, and Treasury notes.
Tax-Exempt Money Fund
A tax-exempt money fund, also called a municipal money market fund, offers earnings that are free from U.S. federal income tax. Depending on the exact securities it invests in, this type of fund may also have an exemption from state income taxes. Municipal bonds and other debt securities primarily constitute these types of money market funds.
Some money market funds are targeted to attract institutional money with a high minimum investment amount, often $1 million.
Money Market Fund Regulation
Money market funds fall under the purview of the SEC in the U.S. This regulatory body defines the necessary guidelines for the characteristics, maturity, and variety of allowable investments in a money market fund.
A money fund mainly invests in the top-rated debt instruments under the provisions, and they should have a maturity period of under 13 months. The money market fund portfolio is required to maintain a weighted average maturity (WAM) period of 60 days or less. This requirement means that the average maturity period of all the invested instruments taken in proportion to their weights in the fund portfolio shouldn’t be more than 60 days.
This limitation ensures that only highly liquid instruments qualify for investments. The investors’ money isn’t locked into long-maturity instruments that can mar the liquidity.
A money market fund isn’t permitted to invest more than 5% in any one issuer to avoid issuer-specific risk. Government-issued securities and repurchase agreements are an exception to this rule, however.
Money market funds also have a required minimum liquidity of at least 25% of the fund’s total assets in daily liquid assets and at least 50% of weekly liquid assets.
Advantages and Disadvantages of Money Market Funds
The primary advantage of a money market fund is that it’s a safe avenue for investing in secure and highly liquid, cash-equivalent, debt-based assets using smaller investment amounts. Money market funds are characterized in the realm of mutual-fund-like investments as low-risk, low-return investments.
Many investors prefer to park substantial amounts of cash in such funds for the short term. Money market funds aren’t suitable for long-term investment goals like retirement planning, however, because they don’t offer much capital appreciation.
Money market funds appear attractive to investors because they come with no loads: no entry 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 at the state level in some cases.
History of Money Market Funds
Money market funds were designed and launched during the early 1970s in the U.S. They gained rapid popularity because they were an easy way for investors to purchase a pool of securities that generally offered better returns than those available from a standard interest-bearing bank account.
Commercial paper has become a common component of many money market funds. Historically, these funds held only government bonds. The transition away from only government bonds resulted in higher yields, although it came with risks as well: The reliance on commercial debt led to the Reserve Primary Fund crisis.
In addition to the reforms that the SEC introduced in 2010, the agency also implemented some fundamental structural changes to the way it regulates money market funds in 2014.
These changes required prime institutional money market funds to float their NAV and no longer maintain a stable price. Retail and U.S. government money market funds were allowed to maintain the stable $1 per share policy. The regulations also provided non-government money market fund boards with new tools to address runs.
More reforms were made in 2023 to enhance liquidity by removing provisions that allowed money market funds to charge fees if their weekly liquid assets fell below the threshold.
Money Market Funds Today
Money market funds have become one of the core pillars of the present-day capital markets. 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.
The interest rates that are available on the various instruments that constitute the portfolio of a money market fund are the key factors that determine the return from a given fund. Looking at historical data is enough to provide sufficient detail on how money market returns have fared.
The Federal Reserve’s monetary policy led to short-term interest rates hovering around 0% between 2010 and 2015. These near-zero rates meant investors saw returns that were significantly lower compared to those in previous decades. The number of investable securities also grew smaller with the tightening of regulations after the 2008 financial crisis.
Quantitative easing (QE) is another economic policy that has had an adverse impact on money market funds. QE is an unconventional monetary policy where a central bank buys government securities or other securities from the market to lower interest rates and increase the money supply.
As the U.S. and other major economies across the globe followed QE measures in the aftermath 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 led to interest rates remaining low for a long duration and diminishing returns from money market funds.
Money Market Fund vs. Money Market Account
A money market fund isn’t the same as a money market account. The former is an investment that’s sponsored by an investment fund company. It comes with risks and carries no guarantee of principal, like other types of investments.
A money market account is a type of savings account offered by a bank or credit union. Money market accounts are insured by the FDIC or NCUA and they let accountholders write checks or use a debit card. They may also come with restrictions, however, such as a limited number of withdrawals from the account per month. This makes them less flexible than a regular checking account.
They are even less risky than money market funds because they are not exposed to market fluctuations, but they may also have slightly lower returns for this reason.
Are Money Market Funds a Good Investment?
It depends on your goals. Money market funds are often among the safest of all investments, with a target value of $1 per share. Money market funds have only dipped below this value, “breaking the buck,” on a small number of occasions associated with financial crises. They’ve quickly bounced back. They aren’t appropriate for long-term investing goals, however, such as retirement investing.
How Safe Is Money in a Money Market Fund?
Money market funds are relatively safe investments. They’re protected by the Securities Investor Protection Corporation (SIPC) in the U.S. However, they aren’t insured by the Federal Deposit Insurance Corporation (FDIC).
What Is the Benefit of Using a Money Market Fund?
Money market funds offer investors high liquidity with a very low level of risk. They’re a useful and profitable place to put cash for a relatively short time frame, rather than keeping it in a traditional savings account where it won’t earn much interest.
The Bottom Line
A money market fund is a type of mutual fund that invests in low-risk, short-term debt instruments. It’s intended as a short-term, liquid investment, providing little capital appreciation but generating modest income through interest.
Money market funds aim to maintain a net asset value (NAV) of $1 per share and are popular for their stability and regular income generation, although they’re sensitive to interest rate fluctuations. Unlike money market accounts, money market funds are investment products without Federal Deposit Insurance Corporation (FDIC) insurance, and their principal value fluctuates.
The regulation and structure of money market funds have evolved to enhance market stability and investor protection, especially following the 2008 financial crisis. Money market funds remain a vital part of the capital markets, offering a safe, liquid investment option for institutional and individual investors.
