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What are Money Market Funds?

October 22nd, 2012 by editor

A money market fund is a type of investment fund whose objective is to earn an interest for the shareholders by maintaining the Net Asset Value (NAV) at $1 per share. These funds are offered by banks, brokerage firms as well as by Mutual Fund firms. The money market funds typically invest in short term (that is less than a period of one year) securities that represent high quality, low risk, liquid debt as well as monetary instruments.

The objective of a money market fund is to provide the shareholders an investment which is safe. The investors can also get easy access to cash-equivalent assets that are characterized as low-risk and low-return investments. As the money market funds tend to offer relatively low returns, investors may not want to opt for long term investment options.

The money market funds are required by law to invest the money in low-risk securities. Hence, the risk in money market funds is comparatively lower than other mutual funds. The money market funds usually pay dividends having short term interest rates. These funds are not federally insured like the money market deposit accounts at the bank.

Money market funds typically invest in low-risk and highly liquid securities such as certificates of deposits, other government securities, as well as commercial papers. The main aim of these funds is to keep the NAV of the fund constant at $1 per share. The yield might also fluctuate. However, there are chances that the NAV of the money market fund goes below $1 in case the investments are not performing very well. Though the chances of investors losing their money by investing in money market funds are rare, the risk cannot be completely avoided.

When an investor tenders the shares of a money market fund, the redemption of the shares needs to be done within 7 days of the tender. As per Section 22(e) of the Investment Company Act of 1940, open-end mutual fund companies may not suspend the investor’s right for redemption, and will pay the proceeds within 7 days of the tender; unless there are certain emergencies or if the Commission by order does not permit to do so for protection of the security holders.

As with any other investment, you need to carefully study all the important information related to investing in a money market fund. You need to go through the prospectus, study the profile of the fund as well as take a look at the latest shareholder report.

The US Securities and Exchange Commission (SEC) regulate these money market funds. The SEC aims at protection of investors’ objectives and tries to ensure that the risks involved are limited. There are several aspects related to money market funds that are governed by SEC Rule 2a-7, such as:

  • Maturity: These funds are not permitted to hold any kind of investments that have a maturity period extending 397 days. Also, it’s important that the fund portfolios’ weighted average maturity is not more than 90 days.
  • Credit Quality: A minimum of 5% of the holdings of the money market fund should be made in such investments that fall into the category of second highest as well as short term rating criteria.
  • Diversification: The portfolio of the money market funds needs to be well diversified. There cannot be any holding in the money market fund that is beyond 5% of the value of the (exceptions being US Treasury as well as holdings of certain government agencies).

Risks involved in Money Market Funds

A money market fund is essentially a security. The fund managers of the money market fund aim to keep the NAV constant at $1 per share. However, if the investments are not performing up to the mark, then this value of $1 per share may drop down and investors may be at the risk of losing some or their entire principal. Though the chances of such kind of losses are rare, it is difficult to avoid the risk completely. The money market funds, unlike the FDIC insured savings accounts, are not federally insured. However, in return of the risk that the investors are bearing, they can expect higher returns from the money market funds.

The rates of the money market funds are also not constant but variable. In short, you cannot predict how much you will get to earn in the next month by investing in a money market fund. The rates tend to fluctuate and may rise or drop. If the price rises, it will be beneficial for you. However, if the price falls down, you might land up earning much less than what you expected.

As money market funds tend to invest in low-risk securities, the chances of earning good returns that are inflation proof is rare. Over an extended period of time, inflation is bound to eat away the returns on your investment.

Advantages of Money Market Funds

  • Safety: The primary objective of a money market fund is capital preservation. The NAV remains constant at $1 per share. In rare cases, when the NAV goes below $1 per share, and the investor is facing losses, the mutual fund company or the sponsor steps in to absorb these kinds of losses.
  • Liquidity: Another advantage of money market funds is the liquidity or the easy access to cash that they provide.
  • Yield: The yield of the money market funds is based on the underlying fund’s holdings. This yield is automatically reinvested in the money market fund through the purchase of some additional shares. The yield offered by money market funds thus makes them an attractive investment option.

Posted in Finance, Investing category.