Many individuals invest in a money market fund, yet have no real idea of what it is. They may be appealing because they earn a little more interest than a checking account. They may also be the only option for your cash sitting in your brokerage account. Either way, what is a money market fund and how does it work?
What is a Money Market Fund?
A money market fund is a fund designed as a place to safely park cash. It is essentially an open-ended mutual fund that seeks to limit exposure to losses (these losses could come from the credit market, liquidity crises, etc.).
Money Market funds attempt to keep the NAV (Net Asset Value) of their investments to $1 at all times, and provide any returns in the form of interest and dividends.
What Do They Invest In?
In order to do what they are looking to accomplish, money market funds typically only invest in short-term debt securities such as US Treasuries and commercial paper.
Because these products are regulated by the SEC (Securities and Exchange Commission), there are limits on what the funds can invest in – specifically restricting the quality, maturity, and diversity of investments.
As such, money market funds only buy the highest rate debt (such as US Treasuries). The portfolios must maintain an average maturity of 60 days or less, and not invest more than 5% in any one issuer, except for the US Government.
Beyond government debt, money market funds also invest in commercial paper (which is a corporate bond with a maturity of less than 270 days), repurchase agreements, short-term bonds, and other money funds. Whatever assets they choose to invest in, they must be highly liquid and of the highest quality.
However, every now and then a money market fund does “break the buck”, meaning its NAV falls below $1. This happens because the investments in the fund lose value. That is why it is essential that you only invest in highly rated money market funds.