Money Market Fund Definition
A money market fund is a form of short-term debt security or open-ended mutual fund with a shorter maturity, offering good returns at high liquidity and low credit risk. The instruments it invests in include US Treasury bills, bank debt funds, and corporate commercial papers that could be taxable or free from tax.
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. 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 dividendsDividendsDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company. for up to 12 months. While an investment fund company sponsors these funds, a fund manager makes the investments on investors’ behalf.
- The money market fund definition refers to low volatility, high liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses., 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., US Treasury billsTreasury BillsTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity., 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 an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks. 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 Treasuries
- Bankers Acceptances
- Certificate of DepositCertificate Of DepositCertificate of deposit (CD) is a money market instrument issued by a bank to raise funds from the secondary money market. It is issued for a specific period for a fixed amount of money with a fixed rate of interest. It is an arrangement between the depositor of money and the bank.
- Corporate Commercial Paper
- Repurchase 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.
These money marketMoney MarketThe money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability. 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.
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:
#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:
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 Paper
- Certificate of Deposit
- Corporate Notes
- Repurchase 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., 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. (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.
This has been a guide to Money Market Fund and its definition. Here we discuss how does it work, its types and returns along with price and interest rates. You can learn more from the following articles –