Money Market Funds: What They Are, How They Work, Pros and Cons (2024)

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, and high-credit-rating, debt-based securities with a short-term maturity (such as U.S. Treasuries). Money market funds are intended to offer investors high liquidity with a very low level of risk. Money market funds are also called money market mutual funds.

While they sound similar in name, a money market fund is not the same as a money market account (MMA). A money market fund is an investment that is sponsored by an investment fund company. Therefore, it carries no guarantee of principal. A money market account is a type of interest-earning savings account. Money market accounts are offered byfinancial institutions. They are insuredby theFederal Deposit Insurance Corporation (FDIC), and they typically have limited transaction privileges.

How a Money Market Fund Works

Money market funds work like a typical mutual fund. They issue redeemable units or shares to investors, and they are mandated to follow the guidelines drafted by financial regulators (for example, those set by the U.S. Securities and Exchange Commission).

A money market fund may invest in the following types of debt-based financial instruments:

• Bankers' Acceptances (BA)—short-term debt guaranteed by a commercial bank
• Certificates of deposit(CDs)—bank-issued savings certificate with short-term maturity
• Commercial paper—unsecured short-term corporate debt
• 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, and therefore, the overall returns from the money market funds are also dependent on interest rates.

Types of Money Market Funds

Money market funds are classified into various types depending upon 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, like those 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 Fund

A Treasury fund invests 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 offers earnings that are free from U.S. federal income tax. Depending on the exact securities it invests in, a tax-exempt money fund may also have an exemption from state income taxes. Municipal bonds and other debt securities primarily constitute such types of money market funds.

Some money market funds are targeted to attract institutional money with a high minimum investment amount (oftentimes $1 million). Still, other money market funds are retail money funds and are accessible to individual investors as a result of their small minimums.

Special Considerations

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 anet asset value (NAV) of $1 per share. Any excess earnings that get generated through interest on the portfolio holdings are distributed to the investors in the form of dividendpayments. Investors can purchase or redeem shares of money market fundsthrough investment fund companies, brokerage firms, and banks.

One of the primary reasons for the popularity of money market funds is 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. It also allows easy calculations and tracking of the net gains the fund generates.

Breaking the Buck

Occasionally, a money market fund may fall below the $1 NAV. This creates a condition that is sometimes referred to with the colloquial term "breaking the buck." When this condition occurs, it may be attributed to temporary price fluctuations in the money markets. However, if it persists, the condition may trigger a moment when the investment income of the money market fundfails to exceed its operating expensesor investment losses.

For example, if the fund used excess leverage in purchasing instruments—or overall interest rates dropped to very low levels nearing zero—and the fund broke the buck, then one of these scenarios could lead to a condition where the fund cannot meet redemption requests. If this happens, regulators may jump in and force the fund's liquidation. However, instances of breaking the buck are very rare.

In 1994, the first instance of breaking the buck occurred. 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.

In 2008, following the bankruptcy of Lehman Brothers, the venerable Reserve Primary Fund also broke the buck. 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. The pullout of money caused the Reserve Primary Fund to liquidate. This event triggered mayhem throughout the money markets.

To prevent this from happening again, in 2010—in the aftermath of the 2008 financial crisis—the SEC issued new rules to better manage money market funds. These rules were intended to provide more stability and resilience by placing tighter restrictions on portfolio holdings and introducing provisions for imposing liquidity fees and suspendingredemptions.

Regulation of Money Market Funds

In the U.S., money market funds are under the purview of the SEC. This regulatory body defines the necessary guidelines for the characteristics, maturity, and variety of allowable investments in a money market fund.

Under the provisions, a money fund mainly invests in the top-rated debt instruments, and they should have a maturity period under 13 months. The money market fund portfolio is required to maintain a weighted average maturity (WAM) period of 60 days or less. This WAM requirement means that the average maturity period of all the invested instruments—taken in proportion to their weights in the fund portfolio—should not be more than 60 days. This maturity limitation is done to ensure that only highly liquid instruments qualify for investments, and the investor’s money is not locked into long-maturity instruments that can mar the liquidity.

A money marketfund is not allowed to invest more than 5% in any one issuer (in order to avoid issuer-specific risk). However, government-issued securities and repurchase agreements provide an exception to this rule.

Advantages and Disadvantages of Money Market Funds

Money market funds compete against similar investment options, such as bank money market accounts, ultrashort bond funds, and enhanced cash funds. These investment options may invest in a wider variety of assets, as well as aim for higher returns.

The primary purpose of a money market fund is to provide investors with a safe avenue for investing in secure and highly liquid, cash-equivalent, debt-based assets using smaller investment amounts. In the realm of mutual-fund-like investments, money market funds are characterized as low-risk, low-return investments.

Many investors prefer to park substantial amounts of cash in such funds for the short term. However, money market funds are not suitable for long term investment goals, like retirement planning. This is because they don’t offer much capital appreciation.

Money market funds appear attractive to investors as they come with no loads—no entry charges 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 in some instances at the state level, too).

It's important to keep in mind that money market funds are not covered by the FDIC's federal deposit insurance, while money market deposit accounts, online savings accounts, and certificates of deposit, are covered by this type of insurance. Like other investment securities, money market funds are regulated under the Investment Company Act of 1940.

An active investor who has time and knowledge to hunt around for the best possible short-term debt instruments—offering the best possible interest rates at their preferred levels of risk—may prefer investing on their own in the various available instruments. On the other hand, a less-savvy investor may prefer taking the money market fund route by delegating the money management task to the fund operators.

Fund shareholders can typically withdraw their money at any time, but they may have a limit on the number of times they can withdraw within a certain period.

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, in general, 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. Previously, money market funds held only government bonds. However, this transition away from only government bonds resulted in higher yields. At the same time, it was this reliance on commercial paper that led to the Reserve Primary Fund crisis.

In addition to the reforms that the SEC introduced in 2010, the SEC also implemented some fundamental structural changes to the way they regulate money market funds in 2016.

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.

Money Market Funds Today

Today, money market funds have become one of the core pillars of the present-day capital markets. For investors, they offer 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 money market fund. Looking at historical data is enough to provide sufficient details on how money market returns have fared.

During the decade spanning from 2000 to 2010, the monetary policies of the Federal Reserve Bank led to short-term interest rates—the rates banks pay to borrow money from one another—hovering around 0%. These near-zero rates meant money market fund investors saw returns that were significantly lower, compared to those in the prior decades. Further, with the tightening of regulations after the 2008 financial crisis, the number of investable securities grew smaller.

Another economic policy in recent years that has had an adverse impact on money market funds is quantitative easing (QE). QE is an unconventional monetary policy where a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.

As major economies across the globe—including the U.S.—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 the diminishing of returns from money market funds.

The Bottom Line

A money market fund is a type of mutual fund that invests in low-risk, short-term debt instruments such as U.S. Treasuries, commercial paper, and certificates of deposit (CDs). These funds offer investors high liquidity with a very low level of risk. While similar in name to money market accounts (MMAs), money market funds differ because they are investment products without FDIC insurance, and their principal value fluctuates. They are 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 are sensitive to interest rate fluctuations.

The regulation and structure of these funds have evolved, especially following the 2008 financial crisis, to enhance market stability and investor protection. Today, money market funds remain a vital part of the capital markets, offering a safe, liquid investment option for institutional and individual investors.