How does a Money Market Fund work?

Most banks and bankers do a poor job at explaining how a money market fund differs from a savings account. As a result, many people believe that a money market fund is a fancy term for a savings account. It’s not.

The reality is there are differences.

Saving Accounts

In the case of a savings account, your principal and interest are guaranteed by the bank and that guarantee is backed by the Federal Deposit Insurance Corporation (FDIC).

The FDIC is an independent agency of the United States government that protects the funds depositors place in banks and savings associations. FDIC insurance is backed by the full faith and credit of the United States government. Since the FDIC was established in 1933, no depositor has lost a single penny of FDIC insured funds.

FDIC insurance covers all deposit accounts, including:

  • Checking accounts
  • Savings accounts
  • Money market deposit accounts
  • Certificates of deposit

 

Having the FDIC back your savings account means that it’s functionally equivalent to something like a 1-day Treasury bill, meaning:

  1. The risk in a savings account is basically zero.
  2. The yield is very low.

 

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Risk – Return Relationship

Generally, the higher the risk of an investment, the higher the potential return. There is no guarantee that you will actually get a higher return by accepting more risk.

Higher risk only increases the potential for higher returns – you could get a lower return or even lose money.
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Money Market Funds

In the case of a money market fund, your investment is placed into a special kind of mutual fund which only holds short term (less than one year) securities representing high quality, liquid debt and monetary instruments such as commercial paper, repurchase agreements, short-term bonds, and other money funds.

A money market fund’s primary purpose is to provide investors with a safe place to invest easily accessible, “cash-equivalent” assets. The targeted goal is to earn interest for shareholders while maintaining a net asset value of $1 per share.

It’s a type of mutual fund, but it is characterized as a low-risk, low-return investment. Because money market funds are investments in securities, you are at risk if those holdings decline in value. And herein lies one of the most important differences between saving accounts and money market funds. Money market funds are not FDIC insured, and as such they carry a greater risk. The risk translates into a higher yield when compared with savings accounts.

Having said that, it is very rare to have a money market fund lose money. Money market funds tend to seek stability and security. It is imperative however to understand that they are not cash equivalent in the absolute sense. They are instead the closest you can get outside of a bank to cash equivalence and many people treat them as cash for this reason.

 

[highlight]Sidenote: Don’t confuse money market funds with money market accounts. Banks in the U.S. offer both savings accounts and money market deposit accounts. These bank accounts offer higher yields than saving accounts, but require higher minimum balance requirements and limit your allowed transactions.[/highlight]

 

The Function of a Money Market Fund

Often large companies need cash for working capital, and instead of opting to tap into their credit lines or issue bonds/equity they go into the market and sell anywhere from 30-360 day IOUs (I owe you’s) at a slight discount to face value.

So if Company X decides they need a million dollars today to fund their latest project they can sell a $1,000,000 IOU for $990,000. When you put your money into a fund, that fund buys various IOU’s from a variety of companies, such as Company X.

Company X gets the money they need quickly, and the money you invested yields you a small return at a low-risk.

 

Money Market Fund’s Today

It’s important to note that there have been a few recent rule changes by the Security Exchange Commission (SEC) that have altered parts of the money market funds model. These changes include:

  1. The SEC currently restricts what maturities money mutual funds can hold.
  2. Money market funds must now hold more “Tier 1” securities – funds can not be allocated to riskier sellers.
  3. “Kill Switches” have been implemented – if there is a run on a fund in too short of a time period assets can be frozen temporarily so that they be liquidated in an orderly manner.

 

The net result of these changes is that yields from money market funds are now lower and will continue to be from here on out. But this also means they are safer (hold less risk) than ever before.

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