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What are money market funds, and how do investors use them?

A Money market fund is a kind of mutual fund that invests in near-term highly liquid assets and are normally used by investors to manage cash and or short-term savings.  

It was developed in the 1970s as an option for investors to purchase a pool of securities that typically provided higher interest than savings accounts in banks.

The fund is a type of investment vehicle that offers investors a variety of elements which includes return of principal, liquidity, and a market-based rate of return, all at a reasonable cost.

Money market Funds can be used as an investment vehicle for both individuals and institutions of all kinds.

The funds are intended to offer investors high liquidity with a very low level of risk.

Just like other mutual funds, in a Money market fund, investors can invest their money or withdraw the invested amount at any time.

How Money Market Fund Works

A Money market fund is a fund that is managed by a professional money manager. Basically, the professional money manager invests the money in different asset classes.

In most jurisdictions, the money market contributes to the smooth functioning of a modern financial economy.

It provides short-term liquidity to governments, commercial banks, and other large organizations.

Money market allows those with disposable income to lend money to those in need of short-term loans and allocates capital towards its most productive use.

For the most part, money market funds invest in 3 asset classes commonly referred to as Money Market Instruments.

These includes:

Commercial paper – Issued by corporations to finance their short-term cashflow needs.

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Treasury bills – When the government borrows money from the public.

Fixed deposits – Deposits in commercial banks.

Think of a money market fund as a pie. So, when you buy shares of the Money market fund basically, you are buying a piece of the pie that includes commercial paper, treasury bills and fixed deposits.

Normally, the fund generates a return that is predominantly driven by the interest rates on the underlying investments in their portfolios.

The interest rates are typically calculated by the fund managers on a money market account daily and make a monthly credit into the accounts of the investors.

In general, money market accounts offer slightly higher interest rates than standard savings accounts.

Also, Money market funds are often structured to cater to different types of investors.

Types of Money Market Funds

The rules governing money market funds vary based on the type of money market fund.

We have different types of money market funds available in the market offered by different financial institutions.

Some funds are generally intended for retail investors, while we have those that typically require high minimum investments.

Those that require high minimum investments are intended for institutional investors.

Generally, money market funds can be broken down into 3 categories.

Prime Money Market Funds

Prime funds are Money market funds that invest generally in variable-rate debt and commercial paper of corporations.

Government Money Market Funds

A Government money fund is one that invests most of its assets in cash, government securities, and/or repurchase agreements that are collateralized fully.

A Treasury fund is a type of government money fund that invests in Treasury Bills, Bonds and Notes.

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Tax-Exempt Funds

Tax-Exempt Funds are Money market funds that invest primarily in securities exempt from local income taxes.

Under usual circumstances, tax-exempt funds are issued by local governments and other municipal organizations.

 How Investors use money market funds

Investors who are extremely risk-averse and are mainly focused on protecting their capital consider Money market funds to be the right investment vehicle for growing their wealth.

The fund is thought to be a low-risk, low-return instrument, and as such, some investors think of them as a short-term strategy to invest large sums of money and achieve greater returns.

The money market fund can help you generate a return on your capital above what is offered by savings accounts in your local commercial bank.

Also, money invested in the money market funds provides significantly less volatility than money invested in the stock market.

The ability to buy and sell shares in money market funds without fees makes many investors think of them.

This makes your investment less expensive, hence conserving cash.  

If you are considering investing in money market accounts, the fund will help you:

  1.     Preserve your capital
  2.     Earn you daily interest on your low-risk investment
  3.     Invest your money for a period less than 1 year
  4.     Park your money for future projects given ease of withdrawal

Key takeaway

As an investor, if you are looking for a safe, short-term investment for your cash, money market funds could be the perfect place to invest.

Money market funds can be a highly useful tool or vehicle for holding the cash component of your investment portfolio.

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The key advantage of money market funds is the fact that they are highly liquid investments.

Money market funds will not make you rich, but they will provide a small return in a low-risk way.

This makes them a good fit for retirees and those who are saving for short-term goals or building an emergency fund.

The main negative of investing in money-market funds is that you’re not going to earn a large enough return to build wealth over time, or even outpace inflation.

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