Money Market Funds: Definition, Operation, Benefits, and Drawbacks
A Money Market Fund: What Is It?
A money market is a mutual fund that typically puts money into short-term, highly liquid securities. These objects include cash, cash equivalents, and borrowing securities with a short maturity with a good credit rating (such as U.S. Treasuries). Money market funds aim to provide investors with significant liquidity and minimal risk. Money market mutuals are another name for money market funds. A money-market fund and money-market accounts are not similar, despite their names being similar (MMA). An investment supported by an investment vehicle firm is known as a money market fund. As a result, there needs to be a leading assurance. A money market account is a savings account that pays interest. Money market accounts are provided by financial institutions. They typically only have a limited number of transaction privileges covered by the Federal Deposit Insurance Corporation (FDIC)
A Money Market Fund’s Operation
Money market funds operate similarly to a standard mutual fund. They must abide by the rules established by financial authorities and issue redeemable units or shares to investors (For instance, those set by the U.S. Securities and Exchange Commission).
Investing in the following categories of debt-based financial products is permitted by money market funds:
- Bankers’ Acceptances (B.A.) are short-term loans with a commercial bank guarantee.
- Certificates of deposit (CDs) are short-term savings certificates issued by banks.
- Commercial paper has no warranty. corporation short-term debt
- Short-term government securities are known as repurchase agreements (Repo).
- Short-term government debt instruments are U.S. Treasuries.
Since the returns from these tools are based on the current market interest rates, interest rates also affect the total returns from money market funds.
Money Market Fund Types
Money market funds are divided into few categories depending on the type of invested assets, the time to maturity, and other characteristics.
Money Market Fund
Floating-rate loans and commercial paper of quasi assets, such as issued by companies, U.S. government agencies, and govt enterprises, are the types of investments made by prime money funds (GSEs).
A government must hold at least 99.5% of its holdings in money, government securities, and fully-collateralized repurchase agreements.
An investment in Treasury securities, including Treasury bills, Treasury bonds, as well as Treasury notes, is made through a Treasury fund.
Funds exempt from taxes
Earnings from a tax-exempt money market fund are excempt from federal income tax in the United States. A money market fund exempt from federal income taxes may also be released from state income taxes, depending on the specific securities it invests in. Such money market funds are generally composed of muni bonds as well as other debt instruments.
Some money market funds have high minimum investment requirements (typically $1 million) to draw institutional capital. However, because of their low minimums, additional money market funds are available to investors as retail money funds.
Net Asset Value Benchmark (NAV)
A money market fund has all the same characteristics as a typical mutual fund, with one significant exception. A money market fund’s net assets value (NAV) is intended to remain constant at $1 per share. Dividend payments are made to investors if any extra earnings from interest on portfolio assets are earned. Investors can buy or sell shares in money market funds through banks, brokerage houses, and investment fund organizations.
Money market funds’ continued preservation of the $1 NAV is one of their key draws. Due to the need to pay investors on time, fund managers are given a steady stream of income. Additionally, it makes it simple to calculate and monitor the fund’s net profits.
Breaking the Buck
A money market fund could once in a while drop below the $1 NAV. As a result, a situation arises that is commonly referred to as “breaking the buck.” Transitory price swings inside the money markets may be to blame when this ailment manifests. Nevertheless, if it continues, the circumstance can lead to a situation in which the money market fund’s investment income falls short of its operational costs or investment losses.
A situation where the fund cannot fulfill redemption requests can arise, for instance, if the fund employed excessive leverage while buying instruments or if overall interest rates fell to deficient levels close to zero. In this case, regulators could intervene and compel the fund to be liquidated. However, breaching the law is relatively uncommon.
The first occurrence of breaking the buck happened in 1994. At $0.96 per share, the Community Bankers U.S. Government Money Market Fund was liquidated. This came about as a result of significant losses the fund suffered during a period of substantial derivatives investing.
Following Lehman Brothers’ demise in 2008, the renowned Reserve Primary Fund likewise went insolvent. Millions of Lehman Brothers’ existing debt were owned by the fund, which saw its NAV collapse to $0.97 per unit due to investors’ panicky redemptions. The Reserve Primary Fund was forced to liquidate due to the withdrawal of funds. The result of this incident was chaos in the financial markets. In 2010, following the 2008 financial crisis, the SEC enacted new regulations to properly handle money market funds to stop this from happening again. These regulations introduced mechanisms for charging liquidity fees, halting redemptions, and tightening limitations on portfolio holdings to increase stability and resilience.
A guide to money market fund regulation
The SEC regulates money market funds in the U.S. This regulatory organization establishes the standards for the qualities, level of maturity, and range of permitted investments in such a money market fund. A money fund is required by the requirements to invest primarily in the best-rated debt securities, and these instruments must have a maturity of fewer than 13 months. The weighted average maturity (WAM) period for the money market fund portfolio must be 60 days or fewer. According to this WAM criteria, the average maturity time of all invested instruments, when weighed according to their share in the fund portfolio, should be at most 60 days. The above maturity restriction is in place to prevent investor funds from becoming trapped in long-maturity instruments that might harm liquidity and to guarantee that only liquid assets instruments are eligible for investing.
More than 5% of any issuer cannot be invested in a money market fund (to avoid issuer-specific risk). The only exceptions to this rule are government-issued securities and buyback agreements.
The benefits and drawbacks of money market funds
Similar investing choices to money market funds include bank money market accounts, ultra-short corporate bonds, and improved cash funds. These investment alternatives could seek more significant returns while investing in a broader range of assets.
A money market fund’s primary goal is to give investors a secure means of making modest investments in safe and secure, liquid, debt-based securities. Money market funds are classified as low-risk, low-return investments in mutual fund-like products. For the near term, numerous investors prefer to put substantial sums of money into these funds. Money market funds, however, are not appropriate for long-term investing objectives like retirement planning. This is because they need to give substantial capital growth.
Advantaged profits to investors by purchasing municipal securities that are free from federal income tax (and in some instances at the state level, too).
- rather a low risk
- extremely liquid
- greater yields compared to bank accounts
- not covered by FDIC
- Lack of capital growth
- Sensitive to changes in interest rates, monetary policy
It’s vital to remember that although money market deposit accounts, internet savings, and certificates of deposit are all protected by the FDIC’s federal insurance, money market funds are not. Money market funds are subject to regulation under the Investment Company Law of 1940, just like other investment instruments.
A proactive investor with the time and knowledge to scout for the finest short-term debt securities- the best interest rates at their selected levels of risk—may want to invest independently in the many available products. On the other side, a less experienced investor would like to use money market funds and hand off the responsibility for money management to the fund managers.
Although fund shareholders typically have unlimited access to their funds, there may be a cap on the number of withdrawals they make in a given time frame.
Money market funds are now one of the fundamental supports of modern capital markets. They provide a diversified, well-managed portfolio with reasonably high liquidity for clients. Money market funds are popular among investors as a haven for their cash while they settle on some other investments or to cover any immediate liquidity needs. The primary variables affecting a money market fund’s performance are the interest payments offered on the various assets that make up its portfolio. Analyzing historical data will provide ample information about how money market gains have performed.
The Federal Reserve Bank’s monetary policy caused short-term interest rates—the fees banks charge each other to borrow money—to linger around 0% from 2000 to 2010. Investors in money market funds had much lower returns than those in earlier decades due to these meager interest rates. Additionally, when restrictions were tightened in the wake of the 2008 economic meltdown, fewer investable assets were available.
Quantitative easing is a different economic measure that has recently hurt money market funds (Q.E.). In an unorthodox monetary strategy known as quantitative easing (Q.E.), a central bank buys government bonds and other assets off the market to reduce interest rates and expand the money supply.
In the wake of the 2008 economic crisis, significant economies worldwide—including the U.S.—implemented Q.E. policies. As a haven, a sizable percentage of the Q.E. funds found their way to money market mutual funds. Due to this flow of money, interest rates remained low for an extended period, which resulted in declining profits from money market funds.
Money Market Funds: Are They Safe?
Yes. With a target share price of $1, money market funds are often one of the safest financial investments. Money market funds have just briefly fallen below this level (referred to as “breaking the buck”) during financial crises before immediately recovering.
Which Money Market Fund Was the First?
“The Reserve Fund,” the first money market mutual fund, debuted in 1971.
Are Money Market Accounts and Money Market Funds the Same Thing?
No. A mutual fund investment known as a money market fund holds relatively short treasuries and other money market securities. A money market account is a bank product that pays interest to depositors.