What Is a Money Market Fund and How Does It Work?

Some things in life should be boring. No one needs sexy plumbing. The less you think about your landlord, the better. You'd run from a mechanic who said "let's try something cool with those brakes." 

Solid, predictable systems are boring but safe. When it comes to your money, that's often a key feature. Most investors have a section of their portfolio that doesn't need to beat the market or pay for the new inground pool—they just want it to be there come unemployment, trade wars, or recessions.

For that section of your portfolio, there is the money market fund.

What Is a Money Market Fund?

A money market fund is a type of fixed-income mutual fund. It invests in high liquidity, high-security assets. Money market funds typically hold primarily debt equities with short maturities (no longer than 397 days, approximately 13 months) and secure credit as well as cash and cash-equivalent assets. This typically means investing in products such as state, federal, or municipal bonds; bank-issued securities; or corporate debt with a high credit rating.

To understand a money market fund, you first need to understand how a mutual fund works.

What Is a Mutual Fund?

A mutual fund is a collection of investments gathered together into a single portfolio. Investors buy shares in that entire portfolio, effectively investing in a piece of every asset the fund holds at once.

Mutual funds serve many purposes, of which two are the most important. The first is to spread risk. A mutual fund returns the average of its collected assets based on their portfolio weights. This protects investors against sudden declines in any one asset (although investors also lose the opportunity to collect sudden gains in any one asset).

A mutual fund also exposes investors to a cross-section of any given market. This lets someone invest in generalized performance as opposed to searching for a single investment that will perform well. For example, say an investor thinks that biotechnology will perform well in the coming years. They can invest in a related mutual fund and collect sector-wide gains rather than hoping to find a single biotechnology company that will do well.

A mutual fund can hold virtually any asset subject to investment. While common mutual funds build their portfolios with stocks, others create commodity portfolios or real estate portfolios, to name two examples.

A fixed-income mutual fund, also sometimes known as a bond fund, is one built around fixed-income-generating securities. These are assets that pay a set rate of return on a set schedule. They are typically (if not almost always) debt assets because debt is the main form of security with a guaranteed rate of return.

What Assets Do Money Market Funds Hold? 

The Securities and Exchange Commission defines three categories of money market funds. Each is structured around what kinds of assets it holds in its portfolio. The SEC requires that any money market fund hold high-security assets with short maturities (typically less than one year). Common investments that money market funds hold include:

• U.S. Treasury securities
• Certificates of deposit
• Federal agency notes
• Short-term corporate debt
• Repurchase agreements
• Eurodollar deposits
• State and municipal bonds

What Are the 3 Types of Money Market Funds? 

Money market funds generally fall into one of three major categories depending on the assets they invest in. =

1. Government Funds

Government funds invest at least 99.5% of their total assets in cash, U.S. Treasury securities, U.S. government securities, and repurchase agreements backed by government securities. The last is a form of short-term lending in which one party sells a government security with the agreement that it will buy it back quickly, often within 24 hours. It is a way of raising short-term capital with secure collateral.

Occasionally, it is possible for a government security not to be backed by the Treasury (such as in the case of federal home loans). This allows investors to build a government fund with non-Treasury securities.

A subset of government funds is Treasury funds. These hold 99.5% of their total assets in cash and U.S. Treasury securities only.

2. Municipal Funds (AKA Tax-Free Funds)

Municipal funds allocate at least 80% of their assets in municipal (local government issued) securities. Generally, these take the form of municipal bonds. Some municipal funds invest in securities that are exempt from local income tax, while others will invest in securities exempt from both state and local income tax.

3. Prime Funds

Prime funds invest in any asset that the SEC allows for a money market fund. They typically hold commercial paper (short-term corporate debt), cash, certificates of deposit, repurchase agreements, and many other investments. The SEC requires that all assets meet the standards of a short-term, highly liquid, highly secure investment.

Institutional vs. Individual Money Market Funds

A money market fund operates differently depending on whether it is being marketed to individual investors or institutional investors.

Prime and Municipal Funds

When marketed to individuals, these funds typically have rules that limit investors to individuals rather than institutions. They list their value to two decimal places and often seek a net asset value of $1.00 (meaning that the fund's total assets add up to $1.00 per share, with excess distributed as dividends to investors). The fund may impose a fee for selling your shares and might suspend trading if its total liquidity falls too low.

When marketed to institutions, these funds typically have rules that limit investors to institutions rather than individuals They generally list their value to four decimal places and are less likely to seek a fixed net asset value. The fund usually imposes a fee for selling shares and typically suspends trading if its total liquidity falls too low.

Government Funds

These funds have the same structure whether marketed to individuals or institutions. They do not have fees or liquidity caps.

Advantages and Disadvantages of Money Market Funds

Money market funds have become a core tool for investors seeking stability. Some of their most important features include

Pros

• Low volatility: A money market fund is one of the most stable investment classes available. This is both due to the nature of the assets they select and due to regulation that restricts them to stable assets.
• Low risk: A money market fund is also one of the least risky investment classes you can choose, again because they are required to invest only in high-security assets.
• High liquidity: Money market funds are easy to trade or cash out of. A typical fund is able to return funds within 24 hours.
• Dividend payments: In order to maintain a stable net asset value, most money market funds make steady dividend payments to investors.

Cons

• Low Rate of Return: Due to their stability and security, money market funds do not make significant payments compared to most other, higher-risk, investments. This rate of return may, in some cases, even fall below inflation, leading to effective losses.
• No Insurance: While heavily regulated, money market funds are not FDIC insured. As a result, it is possible to lose your principal investment.
• Liquidity Risk: It is possible for a money market fund to cap or tax your trades, effectively eliminating the liquidity benefit.
• No Capital Appreciation: Your gains from a money market fund come from the dividends it pays over time. When you redeem your shares you get back only the capital you put in.

What Does "Breaking the Buck" Mean? 

Rarely, a money market fund's value can fall below $1.00. This happens when a fund's investments fail to perform, when the fund's performance falls below its operating costs, or when a fund is over-leveraged. This is called "breaking the buck."

When this happens, the fund may not be able to meet its investors' redemption requests. A redemption request occurs when an investor wants to cash out their principal and return their shares to the fund.

This happens extremely rarely, and preventing it is one of the main reasons why the SEC regulates money market funds so tightly. In this event, however, the SEC forces the liquidation of the entire fund. Preventing this situation is one of the reasons why a prime or municipal fund might have liquidity caps that suspend trading.