Money Market Funds and How They Operate

Last Updated July 12th 2021
6 Min Read

For anyone familiar with the world of mutual funds, money market funds may be a familiar term. But it is possible that, as compared to stocks and regular mutual funds, these are not as widely used and understood among individuals and the small retail investor.

So, what exactly is a money market fund? How is it different from other mutual funds? What are the advantages and risks that an investor needs to understand better before considering them?

Let us take a look at money market funds and how they operate in detail.

What Are Money Market Funds?

Money market funds are a part of the mutual funds universe and share many aspects in common. When an investor buys into a mutual fund or a money market fund, he is buying a share of the common pool of investment. But there are differences between the two that should be understood by an investor. 

To begin with, mutual funds are a professionally managed corpus pooled in by a group of investors with the intent of growth of capital and the expectation of better returns. So are money market funds. But it is in the mix of the investments made and the actual working that the two stand apart. 

The investment that is done with conventional mutual funds is primarily in stocks and bonds and other financial instruments. The distribution of the corpus done is as per the specific purpose of the mutual fund. Some specialise in stocks alone while others can have a mix of stocks and bonds and some others in bonds alone and so on. The focus is on investment vehicles that promise a higher possibility of appreciation and returns. 

Money market funds also share most of the above attributes but the investment done here are in short term securities only. These can include typically lower risk categories of investments like government securities and certificates of deposit. 

How Do Money Market Funds Work?

As the basic principles of investment are the same with both mutual funds and money market funds, there are similarities in the way they operate too. There is the concept of a corpus of funds pooled by a group of investors with the objective to make returns. 

There is also the similarity in the way the fund’s valuation is done. As each investor is buying certain units of the overall fund, he is a part owner of the fund. The valuation takes the NAV (Net Asset Value) route which means the total value of the fund is divided by the total number of units held. These units or shares that comprise the overall fund have an NAV which is a dynamic value that increases or decreases based on the performance of the fund. This, in turn, is a derivative of the overall fund value and reflective of the fund’s health. 

The differences between mutual funds and money market funds come up in the way each operates. To understand this better, we need to examine how money market funds work, where the corpus is invested and the objectives of the investment made.

Money market funds, unlike mutual funds, operate on the premise that risk needs to be kept as low as possible. Also, the instruments the funds invest in are short term debt. Like a traditional mutual fund, they issue units to their investors that are redeemable as per the guidelines laid down by regulators like the US Securities and Exchange Commission. 

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Types Of Money Market Funds

Legally, money market funds are required to be invested in securities that are considerably lower risk. Some of these include government bonds, commercial paper, short term debt and cash instruments, certificates of deposit (CDs), US treasury, banker’s acceptances, repurchase agreements, to name the prominent ones. 

As for the range of money market funds that are available in the market, here are the more popular ones.

Government money fund

A government money fund includes both government funds and treasury funds as well. 

Government funds typically invest at least 99.5% of the overall assets in US Government securities, fully collateralized repurchase agreements and cash. 

Treasury funds include both ‘treasury only’ and ‘treasury’ funds where at least 99.5% of the total assets are invested in US Treasury securities and cash. 

Prime money fund

This fund invests in debt instruments issued by US government agencies and government sponsored enterprises or GSEs, besides those by corporations. These include floating rate debt, commercial paper, corporate notes, repurchase agreements and private instruments from both domestic and foreign issuers. 

Tax exempt money fund

Also known as municipal (both national and state) funds, these funds have their assets invested in municipal securities. The national municipal funds have the advantage of the interest getting exemption from federal income tax. The state municipal funds get an exemption of the interest from both federal and state personal income taxes. 

Advantages of MMF

While mutual funds as an umbrella category of investments are widely accepted and used worldwide, money market funds specifically are growing in acceptance and usage. Given their niche and the strong value proposition, this has evolved as a vehicle for investors who are looking for a safer alternative to mutual funds but better performing over bank accounts. 

Here is a list of the advantages that money market funds offer that should have new investors consider them more seriously. 

Low risk investment options: Mutual funds are seen as relatively less risky than stock market investing. But because there is an element of risk in mutual funds also, money market funds step in as an attractive alternative for the risk averse. 

✅ Better returns than bank accounts: Typically, offers better returns than even bank accounts.

✅ Flexible rate of returns: Pay higher or lower rates over time.

✅ Convenient to transact: You can conveniently write checks to withdraw your funds and get the advantages of dividend earnings as well as easy access to your cash. 

✅ Scores high on liquidity: Money market mutual funds are high on liquidity – you can easily settle your brokerage account trades and retrieve funds.

✅ Low investment thresholds possible: Money market funds have substantially lower purchase requirements that make it easy for investors to buy. 

✅ Accessibility to market information: Money market fund shares are not subject to market timing restrictions and can be bought and sold at any time. You get check-writing privileges and investors are offered same-day settlement.

Disadvantages of MMF

Given below are the disadvantages of money market funds.

 Not FDIC insured: While money market funds have a reputation for being lower on risk, this is somewhat offset by the fact that they do not have the backing of federal insurance. Unlike other mutual funds, these are not covered under FDIC insurance.

Rates are variable: It is a fact that mutual funds, fundamentally, cannot match the kind of high returns that conventional stock market investing can offer. But money market funds, in comparison to regular funds, are even more modest in their ability to render appreciation of the invested capital.

Prone to changes: Another point that is considered a disadvantage for money market funds is its inherent higher degree of sensitivity to changes to economic developments like policy changes, interest rates etc. 

Locked-up funds: The variable nature of the returns means money market funds can become illiquid.

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Do Money Market Funds Suit Your Requirement?

So who can really benefit from money market funds? While mutual funds, in general, find acceptance with a wide range of investors, money market funds are more niche and have a specific purpose that may not suit everyone. 

The profiles of investors for whom money market funds will be most appropriate are:

  • Investors who are risk averse and not comfortable with volatility in the market
  • Those who are not looking to have their capital locked up for prolonged periods and, instead, are on the lookout for shorter term investment solutions
  • Anyone who cannot afford to wait to get access to his invested amount and for whom the possibility of instant liquidity is important 

If you are planning to use money market funds as an investment, learn as much as possible about this investment strategy.

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