Money Market Fund - Explained
What is a Money Market Fund?
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Table of ContentsWhat is a Money Market Fund?How Does a Money Market Fund Work?Investment Options for a Money Market FundTypes of Money Market FundsRegulation of Money Market FundsFactors Affecting Returns from Money Market FundsMoney Market Funds as Investment
What is a Money Market Fund?
A money market fund is a fund that offers a higher interest rate to investors when compared to other funds. It is a type of mutual fund, usually open-ended, that invests in only securities or high liquid cash that have a credit ratings and high rate of return. Investors can purchase units of Money market funds, these funds are regulated by the SEC in the United States. Primarily, a money market fund invests in short-term debt securities that provide higher yield or returns. These short-term debt securities have a duration of less than 13 months, lower risks and higher returns. The US Treasury bills and commercial paper are examples of short-term debt securities of this nature.
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How Does a Money Market Fund Work?
Money market funds are often safe and attractive to investors that which to maximize higher profit within a short period of time. These funds are redeemable units that can be purchased through brokerage firms, banks and mutual funds. Money market funds have the characteristics of standard mutual funds but it only differs in the sense that it maintains a net asset value (NAV) of $1 per share. Additional returns on these funds are given to investors as dividend payment. As a result of the requirement of money market funds to maintain a $1 NAV, investors often make payments to investors which allows easy tracking of profit that a fund generates. In 2012, the proposal of SEC to change the fixed $1 NAV model to a floating NAV model met its waterloo as the industry and entities opposed it. Breaking the buck is a term that describes a situation whereby the NAV of a money market fund falls below $1. This is a case when the investment income is lower than the operating expenses. The use of excess leverage in risk-free investments can result in breaking the buck. Also when the interest rates, yields or returns of an investment drop to an extremely low level, breaking the buck has occurred. The first breaking the buck of a money market fund happened in 1994, then the 2008 financial crisis also caused another occurrence. There are only few instances of breaking the buck, after 2008 however, SEC issued new rules to enhance the stability and resilience of money market funds.
Investment Options for a Money Market Fund
Typically, a money market funds invest in high liquid cash or debt securities with high credit ratings. Investing in a safe debt-security that will yield a high rate of returns for investors is the central goal of a money market fund. The financial instruments that a money market fund can invest in are; Commercial paper, U.S treasuries, bankers' acceptances, repurchase agreements and certificates of deposit (CDs). all these financial instruments are debt based and have overall high rate of returns. These returns are however determined by the interest rates.
Types of Money Market Funds
Generally, money market funds are categorized based on the types of assets, debt-securities or financial instruments they invest in. the maturity date and other terms of the investment also determine their classifications. The categories of money market funds include the following;
- A treasury fund: this is a type of government money fund, this fund is invested in treasury bills, bonds and notes.
- A Tax-exempt money fund: Municipal debt securities is an example of this fund. Investors of this type of money market funds are free from federal income tax or state income tax to a certain degree.
- A Government money fund invests in government securities or financial instruments that have cash as collateral.
- A Prime money fund is a type of money market fund that invests in commercial paper of non-treasury assets issued by government agencies and corporations.
Other categories of money market fund include Institutional money fund and Retail money fund. In the United States, money markets were first introduced and launched in 1971. Due to the high rate of returns offered by these funds, they attracted a large number of investors when they were launched and gained much popularity. Money market funds invest in short-term debt securities which are safe and have higher rates of returns which make the funds appealing to investors. According to the SEC, the money market funds currently hold about $3.0 trillion in assets and this has contributed immensely to their popularity. Also, money market funds are structured like certified investment companies under the 1940 Investment Company Act.
Regulation of Money Market Funds
The SEC regulates the money market funds in the United States, guidelines and standard regulations guiding the practice of these funds are given by SEC. the type of debt securities or financial instruments that these funds can invest in and their maturity period are regulated by the SEC. for instance, money market funds invest in financial instruments with less than 13 months maturity period. Also, the weighted average maturity (WAM) period of these funds is 60 days or less, this means that only highly liquid instruments can be invested in. Not more than 5% is also the investment requirement for one issuer except in cases of government issued securities which are risk-free.
Factors Affecting Returns from Money Market Funds
Despite that money market funds have high rates of return, there are certain factors that can affect this return. Essentially, the interest rates of various financial instruments determine the return on the money market fund invested. For instance, the monetary policies of the Federal Reserve Bank during the financial crisis caused a zero percent return on interest rates unlike in previous decades when money market funds have significant high rates. The aftermath of the financial crisis of 2008 also resulted in smaller returns on interest rates. Furthermore, the Quantitative easing (QE), an unconventional monetary policy of the central bank have a negative effect on money market funds resulting in the generation of lower interests.
Money Market Funds as Investment
The Investment Company Act of 1940 classified money market funds as safe investments that provide investors with high returns by investing in high liquid cash and short-term debt securities with high rates of return. The funds are regulated by the Securities Exchange Commission in the United States. There are other similar investment options that money market funds compete against such as money market accounts and ultrashort bond funds. Money market funds have no-load charges and often invest in municipal securities and tax-exempt financial instruments with high returns. Money market funds are regarded as investment instruments that offer tax-advantaged gains to investors.