Money Market Fund Definition Types How Does It Work

Money Market Fund Definition

Investors with a lower risk toleranceRisk ToleranceRisk tolerance is the investors’ potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor’s age, income, investment objective, responsibilities and financial condition.read more to volatility and limited cash surplus looking for cash-like liquid investment prefer investing in these funds. These funds are liquid investments that provide stability to the asset value and generate income as dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more for up to 12 months. While an investment fund company sponsors these funds, a fund manager makes the investments on the investors’ behalf.

Key Takeaways

The money market fund definition refers to low volatility, high liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more, and minimal risk investment that investors make for a short duration of up to 12 months while receiving earnings as dividends.It is a liquid investment that an investment fund company sponsors, a fund manager manages, and the Securities and Exchange Commission regulates.Usually, it works toward purchasing various short-term cash equivalent securities, such as corporate commercial papersCommercial PapersCommercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory note.read more, US Treasury billsTreasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more, and bank debt funds.Even though it is considered a safe investment, it still carries risks, such as no insurance against loss under the Federal Deposit Insurance Corporation and lower return on investments.

How Does Money Market Fund Work?

Money market mutual funds were created in 1970 to allow investors to invest in a variety of safer securities capable of generating greater returns than an interest-generating savings account. Since their development, these funds have grown at a staggering rate. Nowadays, they have become a popular option for investors looking to earn more than they would with storing their money in a bank account.

These funds will work similarly to mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread more and have maturity periods of up to 12 months. Investors buy shares in the fund, which then purchases short-term debt securities from corporations, governments, and banks. Securities in these funds can be purchased through brokerage firms, investment fund companies, and banks. The debt securities eligible for investment typically consist of:

US TreasuriesBankers AcceptancesCertificate of DepositCertificate Of DepositA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period.read moreCorporate Commercial PaperRepurchase AgreementsRepurchase AgreementsA repurchase agreement or repo is a short-term borrowing for individuals who deal in government securities. Such an agreement can happen between multiple parties into three types- specialized delivery, held-in-custody repo and third-party repo.read more

These money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more instruments are very liquid, meaning investors can convert them quickly into cash if needed. Although these funds do not require a fee to invest in like mutual funds, they do not offer protection against loss under the Federal Deposit Insurance Corporation.

Typically these funds are taxable, but in some cases, they will invest in short-term tax-exempt debt securities, such as municipal securities. With that said, these options are limited and do not offer many choices. After investing in these funds, investors may expect to receive regular income in the form of dividends before the maturity period ends.

Since these funds are considered low-risk, they will not produce any significant returns for investors. It means the ones looking for considerable returns should not invest in a money market mutual fund. However, it is more often used as a way to manage risk and protect retirement savings.

Regulations

A money market mutual fund in the United States must comply with the Securities and Exchange Commission guidelines.

First, the fund must maintain a weighted average maturity (WAM) of 60 days or fewer. It can be attributed to keeping the funds liquid and converting them into cash relatively quickly. Second, it cannot invest over 5 percent of its investments in the bank or corporate debt funds, except the government securities.

Types of Money Market Funds

Based on security holdings, issuers, and maturity periods, different types of money market mutual funds exist. These include:

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#1 – Treasury And Government Funds

Treasury funds will invest in high-quality, short-term debt securities issued by the US Treasury. These are considered safe but offer lower returns, such as:

US Treasury BillsTreasury BondsTreasury BondsA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company.read moreTreasury NotesTreasury NotesTreasury Notes are government-issued instruments with a fixed rate of interest and maturity date. As a result, it is the most preferred option because it is issued by the government (therefore, there is no risk of default) and also gives a guaranteed amount as a return, allowing the investor to plan accordingly.read more

Government funds will invest in short-term government debt securities, such as repurchase agreements (Repo) and Federal Home Loan securities.

Treasury and government funds are available for both institutional and retail purchases.

#2 – Prime Money Fund

These funds will invest in short-term investment vehicles from corporations as well as government-sponsored enterprises and government agencies. The instruments purchased in these funds typically consist of:

Corporate Commercial PaperCertificate of DepositCorporate NotesRepurchase Agreements

In some instances, investors in prime funds can find it more challenging to access their money than they would with government or treasury funds. Also, when the markets are under pressure, these funds may charge a fee.

#3 – Tax-Exempt (Municipal) Money Fund

Some of these funds may be tax-exemptedTax-exemptedTax-exempt refers to excluding an individual’s or corporation’s income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only.read more, depending on the securities. These funds will generally consist of debt securities issued by municipalities and state municipals that are federally tax-exempt.

Tax-exempt funds do not typically provide as many options as other funds and generate a lower yield.

Net Asset Value (NAV) Standard

Investors can calculate their net asset valueNet Asset ValueNet Asset Value is calculated by subtracting the total value of the entity’s liabilities from the total value of its assets and dividing the result by the total number of outstanding shares.read more (NAV) by adding up all of their total assets, deducting all of their total liabilities, and dividing it by the total shares outstanding. The NAV will determine the price for which they can redeem shares. These funds will seek to maintain a consistent net asset value of $1 per share.

The funds that can maintain the $1 per share NAV are typically the more popular choices among investors. It gives them the confidence that funds pay regular dividends, resulting in a reliable income stream.

Returns of Money Market Funds

Money market mutual funds generate lower returns, sometimes under the inflation rate than other types of funds, such as equity funds. The reason for getting lower returns is that the funds are less risky and more predictable.

Although people looking to invest in these funds risk much, they still want to earn slightly more interest than a regular interest-earning savings account. For example, the COVID-19 outbreak created liquidity issues in the debt market that led to massive sell-off, causing investors to invest in these types of funds.

As previously mentioned, certain funds can also have tax benefits for investing in them, adding to the returns.

Risks – Although money market mutual funds are considered one of the safest investments available, they are subject to certain risks that can affect returns.

Interest Rates – When interest rates are low, short-term debt securities will generate significantly lower returns for investors. Sometimes, the money market fund returns might reduce due to inflation and underperformance of short-term underlying investments.

Insurance – Unlike other mutual funds, these funds are not insured by the Federal Deposit Insurance Corporation. Even though these investment vehicles are considered relatively safe, there is no guarantee that investors will not lose their money.

Price – Money market fund rates are subject to stock price fluctuations, as with municipal funds. In this case, if the share price declines in value, investors may be left with less than their investments.