Have you heard of money market funds and wondered what exactly this type of investment is? Money market funds invest in short-term debt securities. As a result, money market funds can be a good option for investors looking for a low-risk investment that offers relatively easy access to their money. But while the name “money market” might sound promising, you should understand what the term means and how these products differ from othermutual funds before investing.
What Is a Money Market Fund?
Money market funds are a type of mutual fund that invest in assets that are generally easy to convert to cash, sometimes called cash equivalents. Because money market funds are managed with the goal of providing low volatility and principal stability, these products are often used by investors who want a safe place to store their money in the short term while also earning some interest.
Among the different types of money market funds investors can tap are those focused primarily on federal government securities and those known as prime funds, which mainly buy corporate debt securities. There are also tax-exempt money market funds, which primarily hold obligations of state and local governments and pay interest that’s generally exempt from federal income taxes. Some money market funds are specifically tailored for retail investors, while others cater to institutional investors.
Money market funds shouldn’t be confused with money market accounts, which are offered bybanks and function similarly to other deposit accounts. Many money market accounts are insured by the Federal Insurance Deposit Corporation (FDIC) or National Credit Union Administration (NCUA) for up to $250,000; money market funds don’t offer this protection. However, money market funds are protected as securities by theSecurities Investor Protection Corporation (SIPC) for up to $500,000 when held at in a customer’s account at a brokerage firm.
What’s Inside a Money Market Fund?
Money market funds invest in a portfolio of short-term, highly liquid debt products, such as Treasury bills, commercial paper, bankers’ acceptances, and certificates of deposit (CDs).
Treasury bills, or T-bills, are short-term debt securities issued by the U.S. Treasury that mature anywhere from a few days to within a year. Commercial paper is a short-term debt instrument issued by a corporation that pledges to repay a specific amount on a specific date without putting up collateral.
Bankers’ acceptances are short-term loans guaranteed by a commercial bank that typically finance international trade transactions.CDs, like savings accounts, are offered by banks and credit unions and pay a specific amount of interest over a fixed time frame. Investors who withdraw money from a CD before it matures can be hit with penalties.
All of these debt products are short-term in nature. Money market funds are required to select their portfolio investments so that the weighted average of the time until the debt holdings mature is no longer than 60 days.
How Do Money Market Funds Work?
Money market mutual fund investors receive dividend income that reflects current short-term interest rates and is redeemable on demand. In addition, a retail money market fund is managed to keep the fund’s net asset value (NAV)—the per-share value of its assets minus its liabilities—stable at $1 per share. Securities and Exchange Commission (SEC) rules allow money market funds to use special valuation methods to keep their NAV steady, whereas the NAVs ofother kinds of mutual fundsfluctuate daily.
On occasion, a money market fund has “broken the buck,” meaning that its NAV fell below $1 per share. But fund managers generally want to avoid that happening, even if it means using their own capital to absorb losses.
The last time a money market fund dropped below $1 was during the 2008 financial crisis, when Lehman Brothers (a large investment bank) declared bankruptcy.Investors in the Reserve Primary Fund, which held $785 million of Lehman Brothers commercial paper, demanded billions of dollars of their money back. The Reserve Fund couldn’t sell its assets quickly enough to meet redemption requests without losing a lot of money, so it froze redemptions and eventually liquidated the fund. The Reserve Fund’s meltdown led many investors to worry about the safety of their other money market fund investments.
Since then, the SEC has raised credit standards for money market funds, reduced maturity requirements and tightened liquidity rules, forcing these funds to invest a higher proportion of their total assets in instruments that could be converted to cash quickly. New rules also gave money market funds tools to stave off outflows during a panic like the one in 2008.
Most recently, the SEC adoptedmoney market fund reforms in 2023 to enhance their resilience after investors pulled out of these funds and other investments during the COVID-19 pandemic in 2020.
All investments carryrisk. However, money market funds are still considered one of the safest investments available to retail investors, and the numerous SEC rules and reforms passed have made them safer. As with any investment, you should evaluate your needs to determine whether a money market fund is the best fit for your financial portfolio andinvestment goals.
