What is a money market fund?
Money market funds are mutual funds that invest in instruments such as cash, cash-equivalent securities, and debt securities with a high credit rating and short-term maturity.
These instruments offer high liquidity and relatively low risk, making them an appealing investment prospect for money market funds.
A money market fund (MMF) is not the same thing as a money market account (MMA). Whereas an MMA is an interest-earning savings account insured by the FDIC, a money market fund is an investment product and therefore does not have FDIC insurance.
What kinds of money market funds are there?
There are several types of money market funds, which vary based on the types of assets in which the fund invests.
Different types of money market funds include:
- Treasury funds, which are 99.5% invested in cash and US Treasury securities.
- Government money funds that invest more than 99.5% of their assets in government securities or cash, or in repurchase agreements collateralized by either.
- Prime money funds that invest in floating-rate debt and non-Treasury commercial paper assets such as government-sponsored enterprises, government agencies, and those issued by corporations. These carry moderately higher risk than a government money market fund, and in turn tend to have higher yields.
- Tax-exempt money funds that invest in tax exempt securities to generate income that is exempt from federal or state income tax.
Money market funds sometimes have large minimum investment thresholds of $1 million or more to limit their availability only to institutional investors, while others offer much lower minimums to allow individuals to invest.
How does a money market fund work?
Money market funds generate a return that is primarily driven by the interest rates on the underlying investments in their portfolios. This means that a change in Federal Reserve rate policy can have a large impact on government money market funds.
For example, during the 2010s, monetary policy implemented by the Federal Reserve took short-term interest rates on inter-bank lending close to zero percent. The impact on money market funds reduced returns significantly compared with previous years.
Are money market funds regulated?
Money market funds in the US are regulated by the Securities and Exchange Commission (SEC). The SEC issues guidelines that dictate which investments, including their maturity and other characteristics, are allowed in a money market fund.
This is under the Investment Company Act of 1940, which also regulates other investment securities in the US. Significant regulatory requirements include:
- Maturity should be less than 13 months.
- Money market funds should mainly invest in top-rated debt instruments.
- Weighted average maturity in the portfolio should be 60 days or less.
The weighted average maturity, or WAM, is calculated by taking the average maturity of the invested instruments, allowing for their relative weights in the portfolio. By keeping this below 60 days, the total liquidity of the fund is protected so that investors' funds cannot be locked into instruments with long-term maturity and poor liquidity.
There is also a requirement that no more than 5% of a money market fund portfolio can be invested with a single issuer (outside of government issued securities). This limit helps to avoid isolated risks that can occur when an issuer encounters difficulties that do not affect the wider market.
Why investors choose money market funds
Money market funds may be thought of as a low-risk, low-return instrument, and as such, some investors consider them part of a short-term strategy to invest large sums of money and achieve greater net returns. Many businesses across both early and late stage consider parking their money in MMFs that earn high yield, given their relative safety.
The ability to buy and sell without fees also adds to their appeal, as does the ability to invest in tax-exempt municipal securities at federal level and to a lesser extent at state level.
Because money market funds do not provide for meaningful capital appreciation, they are are generally not used as part of long-term value investing; for example, investors are unlikely to look to money market funds as a method of planning for retirement.
On balance, a money market fund aims to offer investors a relatively safe investment in secure, accessible, liquid debt-based assets, and are often used as an investment product when individuals and businesses exceed their FDIC insurance limits.