Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Money market funds are sexy again. How do they work?

After years of depressingly low returns on cash, the Fed’s campaign to whip inflation has provided opportunities for respectable yields on relatively safe and liquid investments like money market mutual funds. Brokerage firms and mutual fund families have enjoyed huge inflows into these higher-paying alternatives as investors seek more attractive cash returns.

Yet while these higher yielding money funds are widely viewed as safe and liquid, they are not bank accounts and are not insured by the FDIC. They must be purchased and redeemed by placing a trade just like any other mutual fund and do carry some small risk, especially during times of excessive stress in the economy. These vehicles are regulated by the SEC as investments, and while their incremental return generally justifies the minor additional risk, investors should appreciate how they operate.

Prior to the 1970s, interest on bank savings accounts was regulated and did not adequately compensate for inflation while checking accounts were prohibited from paying interest at all. In 1971, a New York mutual fund firm called Reserve Management Company introduced a new type of mutual fund that invested in very short-term fixed income instruments like corporate and US Treasury bonds and offered higher rates of return as an alternative to low-paying bank accounts. Other fund companies quickly followed suit, launching the money market mutual fund segment that ultimately grew into the $5 trillion behemoth of today.

These alternatives proved so attractive that by 1983 regulators were forced to lift bank interest caps to stem the outflow of deposits and allow banks to offer FDIC-insured money market deposit accounts. Today a wide array of competitive options are available, although money market mutual funds typically sport slightly higher yields than their bank counterparts.

Money funds are divided into three broad categories according to their holdings. Government funds are limited to holding cash and US Government securities, while municipal funds primarily hold state and local government bonds that are typically exempt from federal taxes. The largest and most widely held class, called Prime or general-purpose funds, can purchase government securities as well as short-term corporate bonds and loans, CDs, and some foreign issues.

SEC rules also limit maturities of allowable fund investments to a maximum of 13 months and an overall average maturity of 60 days or less. Funds must also maintain a portion of its securities that can be rapidly converted into cash to meet redemption requests.

Money market funds are simply a specialized subset of the familiar open-end mutual fund universe. Unlike stocks and bonds (or ETFs) that trade actively among buyers and sellers, mutual funds shares are created by the fund when cash flows in from investors. When a holder wants their cash back, the fund must sell sufficient holdings to pay the investors. The shares are then extinguished.

Unlike most stock and bond funds whose daily values vary with market fluctuations, money market funds seek to maintain a constant stable price, typically $1.00 per share. Regulators allow money market funds to use accounting adjustments like amortizing the cost of holdings and adjusting dividend payouts to offset daily market swings, and for the most part they have been remarkably successful. While there is no legal mandate to do so, fund managers understand the imperative of retaining investor confidence in the stable $1.00 value and at times have even subsidized their money funds to stabilize the price. This mechanism works nicely most of the time, until suddenly it doesn’t.

During times of extraordinary stress, investor behavior can shift suddenly as the imperative of safety and liquidity trumps the potential for a few extra points of yield. During the financial crisis of 2008, the Reserve Primary Fund (the original money fund) held bonds issued by Lehman Brothers that defaulted and the fund “broke the buck”, dipping below $1.00 per share.  Then and again during the 2020 pandemic shock, money market funds faced a surge in redemption requests and needed help from the Fed and the US Treasury to meet heavy demands from investors for their money that exceeded their ability to efficiently sell assets to raise the cash. These severe storms were successfully navigated and did not end up costing taxpayers, but as in commercial aviation, every crash is followed by an investigation and rule changes to reduce the odds of a similar accident. In 2020 all the passengers walked away, but the SEC is promulgating some changes arising from its postmortem.

The new rules will require money funds to hold a higher fraction of their investments in highly liquid assets that can quickly be sold to cover redemption requests from investors. Funds will now be required to maintain 25% of their investments in “daily liquid assets”, positions that can be converted to cash in one day, up from the current 10%. Additionally, funds must hold at least 50% in “weekly liquid assets”, up from 25%, intended to bolster investor confidence that they could get their money on demand in all kinds of weather and therefore (hopefully) reduce the potential for a run on fund assets when alarms are ringing.

Pretty much every fund family and broker offers its own version of a money market mutual fund, although you will have to buy them in your account as these are not the default sweep option. With yields now in the 5% neighborhood, it’s worth the effort.

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