A money market fund is a special type of fixed-income mutual fund. Similar to other types of investment funds, a money market mutual fund pools together investor capital to invest in a range of financial securities. However, these funds focused solely on highly liquid, high-credit rating, short-term investments instead of investing in stocks. Usually, these come in the form of short-term debt securities. But alternative asset classes, such as cash or equivalents, can also be popular investments.
These funds are considered to carry some of the lowest levels of risk with minimal volatility. But the tiny risk profile comes paired with mediocre returns. Generally, they serve as an ideal temporary parking spot for cash that needs to be accessed on short notice.
How do money market funds work?
The primary investment objective of a money market fund is to provide a steady stream of income without jeopardising the initial investment of each shareholder. This is achieved by focusing exclusively on high-quality short-term bonds and other types of debt securities.
Regulatory restrictions
Money market funds must remain highly liquid at all times. Therefore, they are regulated under some unique rules. The fund cannot invest in any security with a maturity date longer than 13 months or 25 months for government securities. Furthermore, the weighted average maturity date of the fund must be 60 days or less at any given time. And fund managers cannot invest more than 5% of their portfolio in securities from a single issuer, the exception being government-related securities.
As such, money market fund assets are restricted to specific types of debt-related securities. The list includes:
- Cash – Money that is stored in a savings account which generates small returns through interest.
- Time Deposits – An interest-bearing savings account that matures at a specified time. These typically offer higher interest rates than a regular savings account but charge penalty fees if funds are withdrawn before the maturity date.
- Certificates of Deposits – A savings certificate issued by a bank that generates interest and has a short maturity date.
- Commercial Paper – A form of unsecured corporate debt with a short maturity date.
- Floating-Rate Notes – A debt security issued by governments, financial institutions, or corporations with a variable interest rate that moves in line with a benchmark such as the LIBOR rate. These typically have a maturity date of two-to-five years.
- Short-Dated Government Bonds – Debt issued by a government with a short maturity date.
- Bankers Acceptances – Traditionally used as a payment method for large corporate transactions. However, they also behave similarly to short-term debt secured by a commercial bank.
- Repurchase Agreement – A short-term borrowing instrument central banks use to deal in government securities.
Management fees
Like any mutual fund, a money market fund charges annual management fees. However, due to the low-return-generating nature of this investment vehicle, the expense ratio is typically very low, usually sitting around 0.25%. However, most introduce minimum investment requirements, which can create barriers to entry for some investors.
Share price Calculation
The share price of a money market fund is based on the net asset value (NAV) of its investment portfolio. However, unlike other types of mutual funds, the fund manager constantly seeks to ensure the share price stays at £1 to maximise fund liquidity. To achieve this, returns from interest payments received from its investments or any other gains that push the NAV above £1 are returned to shareholders in the form of a dividend.
Breaking the buck
While extremely rare, a money market fund’s NAV can fall below £1. This situation is known as “breaking the buck”, and if it persists for long periods, it indicates that the investment income is lagging behind operating expenses or investment losses.
In these scenarios, regulators will eventually step in and force the fund to liquidate its assets, returning whatever’s left over to shareholders. This is precisely what happened in 2008 following the bankruptcy of Lehman Brothers. In 2010 the money market fund reform brought new regulations and provisions to provide more protection for investors.
What are the 4 types of money market funds?
Money market funds all share the same investment objective. However, there are multiple methods to achieve it. And depending on the investment strategy being used, a fund can be organised into one of four primary categories.
1. Prime money fund
Invests in high-quality, short-term, non-treasury securities issued by corporations, governments, government-sponsored enterprises, and foreign entities. Prime funds typically generate the highest return out of the different categories of money market funds. However, the difference is only marginal.
Some examples of prime money funds include:
- Schwab Value Advantage Money Fund (SWVXX)
- Fidelity Money Market Fund (SPRXX)
- JPMorgan Prime Money Market Fund-Capital (CJPXX)
2. Government money fund
The fund invests a minimum of 99.5% of its total shareholder capital into cash, short-dated government bonds, or collateralised repurchase agreements. As governments issue all the debt securities within the government money fund portfolio, they are considered to be extremely safe investment vehicles.
Some examples of government money funds include:
- T. Rowe Price Government Money Fund (PRRXX)
- Fidelity Government Money Market Fund (SPAXX)
- Franklin U.S. Government Money Fund (FMFXX)
3. Treasury money fund
A treasury money fund will invest exclusively in standard US treasury-issued short-term debt securities, including treasury bills, treasury bonds, treasury notes, and repurchase agreements. Like a government money fund, a treasury money fund is considered an extremely safe investment.
Some examples of treasury money funds include:
- Vanguard Treasury Money Market Fund (VUSXX)
- Fidelity Treasury Money Market Fund (FZFXX)
- BlackRock Cash Funds Treasury Fund (BRIXX)
4. Tax-exempt money fund
A tax-exempt money fund typically invests around 80% of shareholder capital into short-term government or municipal bonds. Returns generated by a tax-exempt money market fund are immune to income taxes. However, there may be other types of taxes still to pay.
Some examples of tax-exempt money funds include:
- Fidelity SAI Municipal Money Market (FMQXX)
- Vanguard Municipal Money Market Inv (VMSXX)
- Invesco Treasurer’s Ser Tr Prem TxEx Ins (PEIXX)
What are the advantages of money market funds?
Money market funds are a popular investment vehicle among higher net-worth investors. Usually, they are used as a temporary parking spot for excess capital or as a shelter against adverse stock market conditions.
The main advantages of investing in a money market fund are:
- Low Risk – Regulatory restrictions prevent these types of funds from making high-risk investments, making them exceptionally stable investments that don’t endure any significant levels of volatility.
- Short Maturities – As the debt securities found within a money market fund typically mature within less than one year, adverse fluctuations in interest rates have a minimal impact on the value of the fund’s investment portfolio.
- High Liquidity – The short-dated nature of debt instruments enables the fund to be highly liquid to the point where it’s almost on par with depositing money in a savings account.
- Better Returns – Interest payments received from debt securities are paid out to shareholders in the form of a dividend that can provide a reliable source of fixed income that can often exceed the interest offered on a regular savings account.
What are the disadvantages of money market funds?
While money market funds offer some significant short-term advantages, they may not be appropriate as long-term investments.
The main disadvantages of investing in a money market fund are:
- Fees – Like all mutual funds, money market funds charge management fees that combine to form the expense ratio. Due to the limited returns generated by these funds, even low expense ratios can still adversely impact shareholder returns.
- Opportunity Costs – Money market mutual funds significantly underperform the stock market and corporate bond market over long time horizons causing investors to potentially miss out on wealth-building investment opportunities.
- Price Fluctuations – The share price of a money market fund is notoriously stable. However, price fluctuations do occasionally happen. And the net asset value can fall below £1, triggering a regulatory liquidation. In these rare situations, investors could lose a significant chunk of their invested principal.
- No Insurance – Deposits made into a bank account are protected and insured by the Financial Services Compensation Scheme (FSCS) by up to £85,000. However, these protections do not apply to investments made in an investment fund.
Money market fund vs savings account
A money market fund behaves remarkably similar to a regular savings account. Except the latter provides far greater financial protections like depositor insurance, as well as instant access to complete transactions with a debit card or chequebook. So, why would an investor choose one over a savings account?
It ultimately depends on their personal circumstances. Investment funds are inherently riskier due to the lack of investor protections. However, the low-risk nature of debt instruments found in their portfolios makes it very unlikely for investors’ capital to be at any significant risk.
Furthermore, returns achieved by money market funds, even after management fees, have historically outperformed the interest offered on a savings account.
The bottom line
By investing in a money market fund, investors gain exposure to a low-risk diversified debt portfolio that can generate modest returns on cash in the short term. They are considered by many financial advisers to be a “safe” temporary investment for excess capital waiting to be deployed in more long-term investments in the future.
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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.
Saima Naveed does not have a position in any of the financial instruments mentioned in this article. The Money Cog does not have a position in any of the financial instruments mentioned in this article.