What are money market funds?

What are money market funds?

A money market fund (“MMF”) is a specialized type of mutual fund operated by an investment manager that invests in high-quality, short-term instruments such as government securities, repurchase agreements, U.S. Treasury Bills, commercial paper, and other cash equivalents.

Institutional investors and businesses invest in money market funds primarily because they offer high liquidity and low risk; money market securities typically aren’t a leading source of yield.

The U.S. Securities and Exchange Commission (SEC), an independent federal government agency, regulates money market funds under the Investment Company Act of 1940. 

The regulatory SEC Rule 2a-7 outlines the specific criteria for money market funds:

1. Fund assets cannot have a remaining maturity longer than 13 months.
2. An MMF may invest only in U.S. dollar-denominated assets, presenting minimal credit risk at purchase.
3. At most, 5% of total assets can be in illiquid securities.
4. A minimum of 10% of total assets must be daily liquid.
5. A minimum of 30% of total assets must be weekly liquid.
6. Portfolio holdings must be posted monthly on the fund’s website.

Are money market accounts FDIC insured? 

No, the Federal Deposit Insurance Corporation (FDIC) does not insure money market funds. The FDIC protects money deposited in inured banks to help mitigate damage caused by unlikely bank failures, not investment products that aren’t considered deposits. 

Unlike a bank savings account or money market account , a money market fund is held in a personal or corporate brokerage account. 

It is considered an investment vehicle, which means there is a risk that you can lose your entire investment without the protection of FDIC deposit insurance.

How money market funds work

Investors pool their funds together into money market funds to invest in assets on an open-ended, continuous basis. The fund manager issues redeemable shares that investors can buy and sell daily.

The price of these redeemable shares, the Net Asset Value (NAV), is based on the underlying value of the assets in the fund. Money market instruments are designed to have a stable NAV, which should hover around $1.00 share price, deviating only slightly in either direction. 

Fund managers achieve this by collecting income daily and issuing a monthly payout to investors that accrues at a variable daily rate.

It is highly uncommon for a money market fund NAV to “break the buck” or drop below $1.00 per share, but it has happened. 

Fund operators can avoid this occurrence, which indicates a loss of principal for the fund holders, by purchasing stable assets or putting more money into the fund if underlying asset values move negatively.

The different types of money market funds 

Investment managers offer a variety of money market funds. Each fund holds different assets that produce varying expected returns and risk levels; some typically generate higher returns in exchange for higher risk. 

The four main types of money market funds are outlined below.

1. Treasury Funds – Invest in fixed-income securities like cash deposits, U.S. T-Bills, Notes, and Bonds.
2. Government money market funds – Invest in cash deposits, U.S. Treasury Bonds, repurchase agreements, and GSE debt securities.
3. Prime money market funds – invest in Cash Deposits, U.S. Treasury Bonds, Repos, GSE debt, CDs, Commercial Paper, and USD-denominated foreign debt securities.
4. Tax-Exempt funds – Like municipal money market funds, invest in federal income tax and state income tax-exempt securities like municipal bonds. 

What are the risks of money market funds? 

Investing in a money market fund comes with credit, liquidity, and interest rate risks. Below, we dive into these risks with a little more granularity to help paint the full picture of money market fund considerations as you decide on your investment strategy.

Credit risk: You could lose money

As noted earlier, people purchase money market funds because of their perceived low price volatility. A money market fund is an investment vehicle that strives to maintain an NAV of $1.00, but there is no guarantee that it will. 

During extreme financial distress like the ‘07-08 financial crisis, the underlying assets in a money market fund can fluctuate, and you could lose money if you needed to redeem your funds at times like these.

This is without mentioning the liquidity fees that may be charged if you elect to sell your fund shares.

‍Liquidity risk: Your funds may be delayed in getting to you

Most investors in money market funds assume they can redeem and get their cash back at any time. Generally, this is true in peaceful waters; however, some money market funds have built caveats regarding liquidity provisions or limitations on redemption schedules.

In times of market turmoil, investors could attempt to redeem all their shares simultaneously, causing a run on the fund, similar to a run on the bank. In March 2020, this happened to a Goldman Sachs fund, requiring it to inject over $1 billion into it to maintain its NAV and prevent investor losses.

To avoid replays of extreme events, some money market funds now include certain provisions to mitigate future disruptions. Two of the most common are:

• Redemption Schedule– time restrictions for fund withdrawals that slow the flood of cash, leaving the fund in times of uncertainty.
• Redemption Gate– a fee that an investor is charged to disincentivize them from redeeming their money.

Most funds do not have these provisions, but you should always read your prospectus to know exactly what you are buying.

Interest rate risk: You may not get the yield you want

A money market fund rate is not locked in and past performance is not a predictor of future success. Rates change daily as the yield on the assets inside the fund adjusts. If rates rise, this is positive; when rates trend lower, this quickly becomes a problem.

The final consideration we’ll raise is that money market funds are pooled investment vehicles vs. individual asset portfolios. Often, parties will default to money market funds for a pre-packaged solution. Still, your money is important. 

It is worth tailoring the exact investment policy you want for your company rather than settling on one that many others might use as a generic solution.

What are the alternatives to money market funds?

The general point of a money market fund is to keep cash safe and retain quick access to funds, but as alluded to above, it’s not the only type of investment you can use to achieve your goals of safety and liquidity.

Below, we’ve outlined individual instruments that can serve this purpose. Some of these are leveraged as component assets in a money market fund. 

‍Cash – Checking & Saving Bank Accounts

Keeping a large cash balance on hand is a simple solution to the safety and liquidity problem. 

However, this could mean you earn no return and lose buying power due to inflation. These accounts are typically best for holding only as much cash as is needed for immediate operations.

‍Bank Certificate of Deposit

A bank certificate of deposit is a loan to a financial institution for a certain period. The bank generally gives an interest rate above what you can get with government bonds in exchange for locking the money up for a certain amount of time. 

The downside is that you will likely pay an early termination penalty if you need your funds early. These penalties can cost you all or most of the interest you have earned. Always ensure you understand the early termination penalties when buying a CD.‍

U.S. Government Treasuries

Most bank savings products derive their interest rate from U.S. Treasuries. You can buy U.S. government treasuries directly to cut out the bank and the potential penalties. 

The U.S. Treasury is one of the safest assets in the world because the full faith and credit of the U.S. government backs it. They provide next-day liquidity for your funds and cost little to buy or sell.‍

Individual Bond Issuers

Government entities, municipalities, and corporations issue bonds. For example, a local government may issue municipal securities that yield higher yields than U.S. Treasury bonds in a given period. 

That higher yield is due to increased risk; few things match the confidence of a security backed by the U.S. government. 

The two primary risks are below:

• Credit Risk – You can mitigate this risk by only investing in issuers with the highest creditworthiness and projected future ability to maintain payment obligations.
• Mark to Market Risk – Prices can fluctuate because these individual issuer bonds trade in the open market. You face price risk if you need to sell before maturity.

Holding bonds to maturity is the best course of action for corporate cash management purposes.

Wrap-up: How can Rho help?

Like a personal retirement account managed by Vanguard or Fidelity, corporate cash management aims to safely diversify your funds while generating market-competitive yield that sets you up for the future – without introducing unnecessary risk. 

Many tools are at your disposal depending on your cash, investment policy, investment objectives, minimum investment amount, and other important factors – money market funds are one of them.

Money market funds can be an effective treasury management tool, but they come with some risks, which may lead some business owners and seasoned finance teams to elect to own U.S. Treasuries backed by the U.S. government instead. However, executing a corporate treasury management strategy can be time-consuming. 

Rho Prime Treasury is our bespoke treasury management solution designed to make it easy to put your corporate cash to work in FDIC-insured accounts, U.S. Treasury securities, Bank Certificates of Deposit, and investment-grade corporate bonds in your name. 

Want to use Rho Prime Treasury to simplify cash management for your business? Sign up today.