Money Market Funds Explained

Money market funds, also known as money market mutual funds, are a type of low-risk, high liquidity investment. They comprise near-term, short-maturity securities, including cash, cash equivalents, Treasury funds, and certificates of deposit.

Money market funds are regulated by the US Securities and Exchange Commission. They are a popular investment option provided by mutual fund companies, banks, and brokerages. 

The primary purpose of a money market fund is to offer investors flexible opportunities that carry a low level of risk. Money market mutual funds are among the least volatile and most liquid investment types.

It is important to note that money market funds are not the same as money market accounts. 

A money market account is a type of savings account that earns interest on deposits. MMAs are available from banks and other financial institutions and are insured by the Federal Deposit Insurance Corporation.

There are benefits to investing in money market accounts, but in most cases, there are limitations that make them less flexible than other types of savings accounts. 

How Money Market Funds Work

Money market funds work in a similar way to typical mutual funds. They issue shares or units to investors and operate according to guidelines set by the SEC. 

There are various types of debt securities and instruments that funds can invest in. These include:

• Banker’s acceptance
• Certificate of deposit
• Commercial papers
• US Treasury bills
• Repurchase agreements

Money market funds offer a selection of products to investors. The net asset value is designed to stay at $1 per share. There have only been a couple of situations where the value has dropped below $1, including the financial crisis of 2008. 

Excess earnings on money market funds are distributed among investors via dividends. The $1 NAV is one of the primary motivators for investors, as it facilitates regular payments from fund managers to fund holders. 

The returns of the instruments contained within a money market fund are dependent on market interest rates. This means that the overall reward also fluctuates in line with changing interest rates. 

Types of Money Market Funds

Funds are classified into several categories according to the maturity period and the type of investment assets.

Prime Money Market Fund

Also known as general purpose funds, prime money market funds invest in floating-rate debt and commercial papers issued or assigned by non-Treasury entities, including US government agencies or organizations and enterprises sponsored by the government, known as GSEs. 

Government and Treasury Funds

Government and Treasury funds invest in cash and instruments backed by the US government, including Treasury bills, 100% collateralized repurchase agreements, Treasury bonds, and government securities. 

Tax-Exempt Funds

Tax-exempt funds, also known as municipal funds, are exempt from federal taxes. In some cases, they may also be exempt from state taxes. Municipal funds can be classed as national municipal or state municipal. 

Pros and Cons

Although generally safe, money market investments are not free from risk and disadvantages.

Pros

The advantages of money market funds include:

• Very low risk
• High liquidity
• Higher returns than bank account
• Stability
• Regulation of money market funds for added security
• Short-term investment options
• Tax benefits

Cons

The disadvantages of money market funds include:

• Not insured by the FDIC
• Low returns
• Price fluctuation

The History of Money Market Funds

Launched in the US in the 1970s, money market funds were designed to provide a simple, safe way to invest money in securities that often offered better returns than savings accounts. Originally, these funds comprised only government bonds, but today, there is a much wider range of bonds and securities available. 

Following the financial crash in 2008, the SEC introduced new measures to improve money market fund management. 

In 2010, the SEC made rules more robust to enhance stability. It enforced tougher restrictions on money market portfolio holdings. In 2016, it announced further changes to regulations. Prime money market funds were required to float the NAV rather than maintain the stable value. 

Today, money market funds are considered a safe investment option for beginners, as well as experienced investors who want to diversify their portfolios or hold their cash while they wait for new opportunities to come along.