Money market funds

Definition

Money market funds are a type of mutual fund that invests in short-term, high-quality investments such as Treasury bills, commercial paper, and other low-risk, highly liquid instruments. These funds aim to provide investors with a safe place to park cash while earning a higher return than traditional savings accounts, all while maintaining liquidity and capital preservation.

5 Must Know Facts For Your Next Test

1. Money market funds typically seek to maintain a stable net asset value (NAV) of $1 per share, making them less volatile than other mutual funds.
2. These funds primarily invest in short-term debt instruments that mature in less than one year, which minimizes risk and ensures quick access to funds.
3. Investors in money market funds benefit from higher yields compared to traditional savings accounts, though these yields may vary based on interest rate fluctuations.
4. Money market funds are regulated by the Securities and Exchange Commission (SEC), which establishes strict guidelines for their investments to ensure safety and liquidity.
5. While they are considered low-risk investments, money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC), so there is still a degree of risk involved.

Review Questions

• How do money market funds achieve liquidity while providing a return on investment?
  • Money market funds invest in short-term, high-quality debt instruments that mature quickly, ensuring that they can easily convert these assets into cash when needed. By focusing on low-risk securities like Treasury bills and commercial paper, these funds maintain liquidity while offering returns that are typically higher than those found in traditional savings accounts. This balance allows investors to have access to their funds without sacrificing the potential for earning interest.
• Evaluate the risks associated with investing in money market funds compared to other investment options.
  • While money market funds are generally considered low-risk due to their investments in short-term and high-quality securities, they still carry some risks that investors should be aware of. Unlike bank deposits, money market funds are not insured by the FDIC, meaning there is a possibility of losing principal if the fund's investments perform poorly. Additionally, during times of economic stress or rising interest rates, yields may decline, making them less attractive compared to other investment options like stocks or bonds.
• Assess the impact of regulatory changes on the operation and appeal of money market funds over time.
  • Regulatory changes, particularly those implemented after the 2008 financial crisis, have significantly affected the operation and appeal of money market funds. For instance, new rules require certain institutional money market funds to float their net asset value instead of maintaining a stable $1 NAV. These changes aimed to enhance transparency and reduce systemic risk but have made money market funds less attractive for some investors seeking stability. Consequently, these shifts have led many investors to reconsider their allocation strategies within the broader context of their investment portfolios.

Related terms

Mutual Fund: An investment vehicle that pools money from multiple investors to purchase a diversified portfolio of stocks, bonds, or other securities.

Treasury Bills:

Short-term government securities issued by the U.S. Treasury with maturities of one year or less, commonly used in money market fund investments.

Liquidity: The ease with which an asset can be quickly converted into cash without significantly affecting its value.