What are Money Market Funds?

What began as a niche product has now become a staple in the investment world.

What are Money Market Funds?

Money Market Funds (MMFs) have come a long way since their inception in the 1970s. Born out of regulation changes allowing funds to pay market interest rates, MMFs came about as a new option for short term cash management. What began as a niche product has now become a staple in the investment world.

In the early days, MMFs invested in top rated money market securities like commercial paper, certificates of deposit, and short term bonds. This provided higher returns on idle cash than traditional bank products, while emphasising preservation of capital and daily liquidity. MMFs aimed to bridge the gap between savings accounts and stocks/bonds.

Fast forward to today, MMFs hold over 6 trillion in assets under management globally. By providing stability, modest interest, and chequebook-like flexibility, they cemented their status as a cash management vehicle for conservative investors. From retail clients’ rainy day funds to treasury accounts at Fortune 500 companies, MMFs are ubiquitous.

In this article, we will explore:

MMFs Basics - what they invest in and who uses them
The advantages and disadvantages of these funds
Recent growth trends and outlook for the future

Whether you are new to investing or a professional, read on to learn if money market funds deserve a place in your portfolio.

Money Market Fund Basics

An MMF is a type of mutual fund that invests in highly liquid, short term securities with high credit quality and low risk. The overarching goal of MMFs is preservation of capital while generating a modest yield for investors.

To explain how they work, MMFs take your money and purchase short term (13 months or less) money market instruments like T-Bills from the government, CDs from banks, or commercial paper from blue chip corporations. This provides diversification across very safe investments that roll over quickly to maintain access to your cash.

Retail investors may use MMFs to house an emergency fund or cash for a near term expenditure like a home down payment. Companies use them to manage payroll and operating accounts. Pension funds park a portion of assets in MMFs for steady returns on cash needed for distributions.

The appeal is earning higher interest than a savings account with minimal risk since MMFs own stable, highly-rated securities. Your principal is protected while generating modest returns around 1-2%, making MMFs a popular place to stash spare cash and retain liquidity. When you need your money, sell your shares and cash out.

Advantages & Disadvantages

One of the main benefits of money market funds is their low risk profile that focuses on capital preservations. MMFs achieve this by sticking to secure short term securities like CDs and commercial paper. For investors with short term goals, this conservative allocation provides a safe haven compared to stocks, crypto, or bonds which can experience bigger swings. Plus, the short duration minimises exposure to interest rate shift, providing more stability. Your 6 month house down payment would benefit from the low risk shelter of a MMF versus volatility in other assets.

MMFs also provide high liquidity since they invest solely in securities with active secondary markets. This gives investors the flexibility to easily buy and sell fund shares as needed, which is a crucial perk for those with unpredictable cash flow needs. The ability to readily redeem shares with same or next day settlement provides convenience and versatility. You can think of it like a checking account - the cash is there when you need it.

Some investors also use MMFs for their tax efficiency. Certain MMFs invest exclusively in municipal bonds, allowing them to pay tax exempt dividends. For investors in higher tax brackets, this can provide savings compared to fully taxable interest accounts. However, the trade off is these municipal MMFs may offer even lower yields than normal prime or government MMFs.

While MMFs provide safety and liquidity, they come with the cost of muted returns. Yields are sometimes low, commonly around 1-3%, and often fail to outpace inflation. This can result in a gradual loss of purchasing power over time. Additionally, even small expense ratios and fees can noticeably reduce profits due to the already modest returns. For example, a 1% expense ratio cuts the yield on a 2% MMF in half. Lastly, unlike savings accounts, MMFs are not insured by the Federal Deposit Insurance Corporation (FDIC). Meaning that in the unlikely event of the fund facing financial difficulties, investors could risk losing a portion or all of their investment, a scenario that while rare, is worth considering.

MMF Trends

MMFs have been growing steadily, both across Europe and in the United States.

Assets under management in European domiciled MMFs grew by over 10% in 2022, reaching €1.6 trillion according to industry data (LSEG). This increase highlights the growing appeal of MMFs as an alternative to traditional bank deposits for European investors seeking to preserve capital in a low yield environment.

Within Europe, euro-denominated MMFs saw the highest inflows last year benefitting from the European Central Bank’s deposit rate. Investors flocked to prime MMFs yielding 0.5% or more, well above most saving accounts. Conservative investors and corporations continue utilising MMFs for their liquidity needs.

Meanwhile in the US, MMF growth has been equally impressive, with assets rising 22% to over $6 trillion in 2022 (LSEG). As the Federal reserve rapidly jacked up rates, money market yields soared to around 4% - way better than you'll get in a savings account (IBD). Although the Fed plans to cut rates in 2024, analysts say MMFs should still beat bank yields for some time, keeping them an attractive cash destination.

JPMorgan strategists estimate over $5 trillion in MMFs as core holdings, representing institutional and individual cash allocation primarily for liquidity needs rather than long term investments (Reuters). Even with potential market fluctuations, this core pool of capital is expected to remain within the MMF space due to its inherent utility and operational convenience for managing accessible cash reserves.

The impressive and steady growth of MMFs highlights their integral role providing modest returns plus security and liquidity that traditional accounts lack. This steady rise looks set to continue in 2024 (Reuuters). While rate cuts may slow inflows at the margins, analysts say substantial “core” money is firmly parked in MMFs for their utility.

Conclusion

In summary, money market funds are like a reliable friend - always there when you need ready cash with stability and modest interest. These funds invest in highly secure short term securities to preserve capital while earning above traditional savings.

MMFs provide a safe haven for temporary cash from retail investors, corporations, and institutions alike. The conservative investments and quick maturities minimises risk. Yet MMFs offer far higher returns than standard bank accounts thanks to exposure to money markets.

While MMFs may not offer exceptionally high returns, their strength lies in the steady yield and daily liquidity - always available when you need it. Assets under management have climbed over the years as investors increasingly deposit cash in MMFs for their utility and convenience compared to traditional options.

Even with potential shifts in monetary policy, a significant amount of core cash is likely to remain in MMFs rather than going into alternative investments. These funds will continue providing stability, easy access to cash, and modest interest in an uncertain economic environment.

Looking to gain exposure to Euro Money Markets? Explore The Moreliquid Money Market EUR (MMMEUR) Token. Qualified Investors only. EEA Investors only.

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