Understanding Money Market Funds
Effective cash management is critical for any organization. Holding the right amount of cash, in the right types of vehicles, can have a major impact on an organization’s ability to meet its responsibilities and goals.
Organizations can hold their cash in a variety of vehicles. Each option offers a different combination of key characteristics, including:
- Safety: preservation of your principal value
- Liquidity: the ability to withdraw your cash on demand
- Potential return: interest income the vehicle generates
Money market funds are among the most common and useful tools for managing cash holdings. Any professional who may be asked to weigh in on decisions related to cash management can benefit from a basic understanding of money market funds — what they are, how they work, and how they compare to other options.
What is a money market fund?
A money market fund is a mutual fund that invests in cash equivalent short term high quality debt instruments. Money market funds have a key feature that distinguishes them from other cash options: most use amortized cost accounting, which enables them to maintain a consistent net asset value (NAV) of 1.00 per share in nearly all circumstances. To pursue that goal, they invest in very short term debt safety and liquidity as the primary objective.
Depending on the specific fund, eligible investments may include:
- Government/Sovereign Treasuries debt— Securities issued and guaranteed by their respective government.
- Government agency debt — Securities issued by government agencies like the US based Federal Home Loan Bank.
- Corporate or Financial Institution debt — Securities such as commercial paper, certificates of deposit, medium-term notes, or other unsecured debt issued by some of the largest corporations and banks.
- Repurchase agreements — A form of short-term lending in which an investor agrees to loan money in exchange for collateral in excess of the loan. Most repurchase agreements are short-term loans with maturities of one day to one week.
Common Types of Money Market Funds
There are different types of money market funds, differentiated by the kinds of assets they are allowed to hold. The following types are most common:
Common Rules Governing Money Market Funds
There are many rules that govern money market funds in both Europe and the US that limit risk and increase the safety of the vehicle. Besides the rules on the investment strategies listed above the two major rules have to do with duration and liquidity. There are limits to duration on the portfolio and the specific investments and there are minimum levels of liquidity that must be held by the fund.
- Each fund is subject to three duration limitations. (Please reference the glossary of terms for specific definitions)
- Weighted average maturity is limited to 60 days. This is a measure of sensitivity to changes in interest rates.
- Weighted average life is limited to 120 days. This is a measure of credit sensitivity in the portfolio
- Legal final maturity of a security is limited to 397 days except with specific government debt.
- Each fund must hold certain levels of liquidity. Liquidity in a money market fund is defined as the percent of a fund that matures in one business day (daily) and 5 business days (weekly) or meets specific security criteria (government agency or sovereign debt) based the domicile of the fund. US funds must hold at least 25% in daily and 50% in weekly liquidity and European funds must hold 10% and 30% respectively.
There are many additional rules that govern money market funds as well as specific rules that NRSRO Rating Agencies apply to money market funds. For a more detailed discussion on these rules please reach out to your State Street representative.
Fund types differ in their levels of risk, potential return, and tax-efficiency. Be sure to request official fund documents such as a fact sheet and prospectus whenever researching and or choosing investment options.
Potential Advantages and Disadvantages of a Money Market Fund
The primary appeal of a money market fund lies in its combination of cash-like liquidity and stability with the potential to generate a market rate of return. A money fund’s stability and liquidity may be essential for an organization to perform certain critical functions, such as meeting payroll, paying operating expenses, making debt payments, and funding capital expenditures. For a large organization managing substantial volumes of cash, the potential to earn market returns from a diversified portfolio of investments may generate revenues that help strengthen the organization. For these reasons, money market funds may complement bank deposit accounts. Deposits are stable and can be liquid but expose you to a single bank and may not pay a competitive return. The rate a Bank deposit pays is determined by the specific bank and can change at any time without notice.
A possible disadvantage of a money market fund is the management fee it charges. The fee is disclosed in the fund’s prospectus, and typically in other fund materials as well. One should consult fund documents to know exactly what you are paying for your investment. Additionally, one should understand who the investment manager is. How committed to the business they are and what their history has been managing money market funds.
How to Evaluate a Money Market Fund. What is the right fund for you?
There are many attributes that can be looked at to evaluate a money market fund. Some of those include the following:
- The size of the fund matters but the cash flows in the fund matter more. The money fund industry has consolidated over the past 30 years. There are now fewer providers and their funds are very large. When choosing a fund it is important to look at the size of the fund and also the cash flows, or shareholder activity. You want to insure that is not gaining or losing a significant portion of its assets on a frequent basis. Additionally some investors will limit their investment to no more than 10% of the fund’s assets.
- Many funds will have a rating agency rate their funds. Moody’s, S&P or Fitch are the most common and they will provide a AAA rating. This rating will come with additional rules and oversight to what has already been established by the local regulator.
- The history and commitment of the asset manager to the cash business is also an important criteria when evaluating funds. One needs to ensure that the investment advisor is committed to the business and investing in the business. The advisor should have a long history of managing funds with a stelar track record of prioritizing the safety and liquidity of your investments.
Additional Considerations
There are risks to all forms of investing, even in money market funds. One should always perform thorough due diligence before investing.
| Money Market Fund | Typically, a commingled vehicle that must abide by a set of rules established to minimize risk and maximize safety. They can be globally available to a variety of investors, large and small, retail or institutional |
| Net Asset Value (NAV) | The weighted average price of all of the assets in a commingled vehicle (fund) |
| Amortized cost accounting | An accounting method that values securities based on the price paid for them and then amortizing the security to its maturity value, usually par. |
| Constant (stable) net asset value (CNAV) | A type of accounting that a fund can use to price the assets at their amortized cost so the NAV of the fund remains at 1.00 and does not vary. Most money market funds use amortized cost accounting, enabling them to maintain a 1.00 NAV. |
| Mark-to-market accounting | A method of accounting that values the asset at its current market price. Almost all stock and bond funds use mark to market accounting to value the securities they own. |
| Variable (floating) net asset value (VNAV) | Certain money market funds use mark to market accounting and have variable NAVs, meaning their price per share fluctuates based on the market value of the securities they own. |
| Liquidity fees | Certain Prime funds in the US and LVNAV funds in Europe could impose a fee on withdrawals given certain fund criteria. This is done to reduce outflows in times of crisis. In the US the SEC has clearly defined how a fee would be applied to an institutional prime money market fund. In Europe LVNAV funds have discretion when applying a fee. |
| Redemption gates | Redemption gates exist for some European LVNAV money market funds and can be used at the managers discretion. Gates have been eliminated for US registered MMFs |
| LVNAV | LVNAV stands for Low Volatility NAV. This is a specific type of fund registered in Ireland or Luxembourg. It uses amortized cost accounting and trades at 1.00. |