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 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 order your copy of investopedia s what to do with 10 000 magazine for more wealth building advice types of money market fundsmoney market funds are classified into various types depending on the class of invested assets the maturity period and other attributes 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 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 1a treasury fund invests in standard u s treasury issued debt securities such as treasury bills treasury bonds and treasury notes 2a 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 3some 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 considerationsall the features of a standard mutual fund apply to a money market fund with one key difference a money market fund aims to maintain a net asset value nav of 1 per share 4 any excess earnings that get generated through interest on the portfolio holdings are distributed to the investors in the form of dividend payments investors can purchase or redeem shares of money market funds through 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 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 fund fails to exceed its operating expenses or 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 5 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 6 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 suspending redemptions 7in 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 8a money market fund 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 9advantages and disadvantages of money market fundsmoney 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 very low riskhighly liquidbetter returns than bank accountsnot fdic insuredno capital appreciationsensitive to interest rate fluctuations monetary policyit 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 10 like other investment securities money market funds are regulated under the investment company act of 1940 9an 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 fundsmoney 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 11commercial 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 11these 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 9today 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 