A money market fund (also known as money market mutual fund) is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are widely (though not necessarily accurately) regarded as being as safe as bank deposits yet providing a higher yield. Regulated in the US under the Investment Company Act of 1940, money market funds are important providers of liquidity to financial intermediaries.[1]
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Money market funds seek to limit exposure to losses due to credit, market, and liquidity risks. Money market funds in the United States are regulated by the Securities and Exchange Commission's (SEC) Investment Company Act of 1940. Rule 2a-7 of the act restricts the quality, maturity and diversity of investments by money market funds. Under this act, a money fund mainly buys the highest rated debt, which matures in under 13 months. The portfolio must maintain a weighted average maturity (WAM) of 60 days or less and not invest more than 5% in any one issuer, except for government securities and repurchase agreements.[2]
Unlike most other financial instruments, money market funds seek to maintain a stable value of $1 per share. Funds are able to pay dividends to investors.[2]
Securities in which money markets may invest include commercial paper, repurchase agreements, short-term bonds and other money funds. Money market securities must be highly liquid and of the highest quality.
In 1971, Bruce R. Bent and Henry B. R. Brown established the first money market fund in the U.S.[3] It was named The Reserve Fund and was offered to investors who were interested in preserving their cash and earning a small rate of return. Several more funds were shortly set up and the market grew significantly over the next few years.
Money market funds in the US created a loophole around Regulation Q,[4] which at the time prohibited demand deposit accounts from paying interest and thus money market funds can be seen as a substitute for bank accounts.
Outside of the U.S., the first money market fund was set up in 1968 and was designed for small investors. The fund was called Conta Garantia and was created by John Oswin Schroy. The fund's investments included low denominations of commercial paper.
In the 1990s, bank interest rates in Japan were near zero for an extended period of time. To search for higher yields from these low rates in bank deposits, investors used money market funds for short-term deposits instead. However, several money market funds fell off short of their stable value in 2001 due to the Enron bankruptcy, in which several Japanese funds had invested, and investors fled into government-insured bank accounts. Since then the total value of money markets have remained low.[4]
Money market funds in Europe have always had much lower levels of investments capital than in the United States or Japan. Regulations in the EU have always encouraged investors to use banks rather than money market funds for short term deposits.[4]
Money market funds seek a stable net asset value, or NAV (which is generally $1.00 in the US); they aim never to lose money. If a fund's NAV drops below $1.00, it is said that the fund "broke the buck".
This has rarely happened: Up to the 2008 financial crisis, only three money funds have broken the buck, in the 37-year history of money funds.
It is important to note that, while the funds are managed in a fairly safe manner, there would have been many more failures except that the companies offering the money market funds had, in the past, stepped in when necessary to support the fund and avoid having the funds "break the buck". This was done because the expected cost to the business from allowing the fund value to drop -- in lost customers and reputation -- was greater than the amount needed to bail it out.[5]
The first money market mutual fund to break the buck was First Multifund for Daily Income (FMDI) in 1978, liquidating and restating NAV at 94 cents per share. An argument has been made that FMDI was not technically a money market fund as at the time of liquidation the average maturity of securities in its portfolio exceeded two years.[6] However, prospective investors were informed that MFDI would invest "solely in Short-Term (30-90 days) MONEY MARKET obligations." Furthermore, the rule which restricts the maturities which money market funds are permitted to invest in, Rule 2-a7 of the Investment Company Act of 1940, was not promulgated until 1983. Prior to the adoption of this rule, a mutual fund had to do little other than present itself as a money market fund, which FMDI did. Seeking higher yield, FMDI had purchased increasingly longer maturity securities and rising interest rates negatively impacted the value of its portfolio. In order to meet increasing redemptions the fund was forced to sell a certificate of deposit at a 3% loss, triggering a restatement of its NAV and the first instance of a money market fund "breaking the buck."[7]
The Community Bankers US Government Fund broke the buck in 1994, paying investors 96 cents per share. This was only the second failure in the then 23-year history of money funds and there were no further failures for 14 years. The fund had invested a large percentage of its assets into adjustable rate securities. As interest rates increased, these floating rate securities lost value. This fund was an institutional money fund, not a retail money fund, thus individuals were not directly affected.
No further failures occurred until September 2008, a month that saw tumultuous events for money funds. Though, as noted above, other failures were only averted by infusions of capital from the fund sponsors.[8]
Money market funds increasingly became important to the wholesale money market leading up to the crisis. Their purchases of asset-backed securities and large-scale funding of foreign bank's short-term US denominated debt put the funds in a pivotal position in the market place.[4]
The week of September 15, 2008 to September 19, 2008 was very turbulent for money funds and a key part of financial markets seizing up.[9]
On Monday, September 15, 2008, Lehman Brothers Holdings Inc. filed for bankruptcy. On Tuesday, September 16, 2008, Reserve Primary Fund, the oldest money fund, broke the buck when its shares fell to 97 cents after writing off debt issued by Lehman Brothers.[10]
The resulting investor anxiety almost caused a run on money funds, as investors redeemed their holdings and funds were forced to liquidate assets or impose limits on redemptions: through Wednesday, September 17, 2008, prime institutional funds saw substantial redemptions.[11][12] Retail funds saw net inflows of $4 billion, for a net capital outflow from all funds of $169 billion to $3.4 trillion (5%).[11]
In response, on Friday, September 19, 2008, the U.S. Department of the Treasury announced an optional program to "insure the holdings of any publicly offered eligible money market mutual fund—both retail and institutional—that pays a fee to participate in the program". The insurance will guarantee that if a covered fund breaks the buck, it will be restored to $1 NAV.[12][13] This program is similar to the FDIC, in that it insures deposit-like holdings and seeks to prevent runs on the bank.[9][14] The guarantee is backed by assets of the Treasury Department's Exchange Stabilization Fund, up to a maximum of $50 billion. It is very important to realize that this program only covers assets invested in funds before September 19, 2008 and those who sold equities, for example, during the recent market crash and parked their assets in money funds, are at risk. The program immediately stabilized the system and stanched the outflows, but drew criticism from banking organizations, including the Independent Community Bankers of America and American Bankers Association, who expected funds to drain out of bank deposits and into newly insured money funds, as these latter would combine higher yields with insurance.[9][14]
The crisis almost developed into a run on the shadow banking system: the redemptions caused a drop in demand for commercial paper,[9] preventing companies from rolling over their short-term debt, potentially causing an acute liquidity crisis: if companies cannot issue new debt to repay maturing debt, and do not have cash on hand to pay it back, they will default on their obligations, and may have to file for bankruptcy. Thus there was concern that the run could cause extensive bankruptcies, a debt deflation spiral, and serious damage to the real economy, as in the Great Depression.
The drop in demand resulted in a "buyers strike", as money funds could not (because of redemptions) or would not (because of fear of redemptions) buy commercial paper, driving yields up dramatically: from around 2% the previous week to 8%,[9] and funds put their money in Treasuries, driving their yields close to 0%.
This is a bank run in the sense that there is a mismatch in maturities, and thus a money fund is a "virtual bank": the assets of money funds, while short term, nonetheless typically have maturities of several months, while investors can request redemption at any time, without waiting for obligations to come due. Thus if there is a sudden demand for redemptions, the assets may be liquidated in a fire sale, depressing their sale price.
An earlier crisis occurred in 2007–2008, where the demand for asset-backed commercial paper dropped, causing the collapse of some structured investment vehicles.
The Investment Company Institute reports statistics on money funds weekly as part of its Mutual Fund Statistics, as part of its industry statistics, including total assets and net flows, both for institutional and retail funds. It also provides annual reports in the ICI Fact Book.
As of December 11, 2008, almost 2,000 money funds are in operation, with total assets of nearly US$3.8 trillion.[15] Of this $3.8 trillion, retail money market funds had $1.282 trillion in Assets Under Management (AUM), of which 77% was in tax-exempt funds. Institutional funds had $2.5 trillion under management of which the overwhelming majority - 93% - was tax-exempt.[16]
Institutional money funds are high minimum investment, low expense share classes which are marketed to corporations, governments, or fiduciaries. They are often set up so that money is swept to them overnight from a company's main operating accounts. Large national chains often have many accounts with banks all across the country, but electronically pull a majority of funds on deposit with them to a concentrated money market fund.
The largest institutional money fund is the JPMorgan Prime Money Market Fund, with over US$100 billion in assets. Among the largest companies offering institutional money funds are BlackRock, Western Asset, Federated, Bank of America, Dreyfus, AIM and Evergreen (Wachovia).
Retail money funds are offered primarily to individuals. Retail money market funds hold roughly 33% of all money market fund assets.
Retail money funds come in a few different breeds: government-only funds, non-government funds and tax-free funds. Yields are typically somewhat higher than in savings accounts. Investors will obtain a slightly higher yield in the non-government variety, whose principal holdings are high-quality commercial paper and other instruments; of course, such funds may get in trouble if fears emerge about previously well-regarded companies.
Instruments of the United States Government (and funds holding them) are usually exempt from state income taxes, and conversely, "muni bond funds" are generally exempt from federal income tax. In both cases, yields are (almost always) lower, but may result in better conservation of value depending an individual investors' tax situation.
The largest money market mutual fund is Fidelity Investments' Cash Reserves (Nasdaq:FDRXX), with assets exceeding US$110 billion. The largest retail money fund providers include: Fidelity, Vanguard (Nasdaq:VMMXX), and Schwab (Nasdaq:SWVXX).
Banks in the United States offer savings and money market deposit accounts, but these shouldn't be confused with money mutual funds. These bank accounts offer higher yields than traditional passbook savings accounts, but often with higher minimum balance requirements and limited transactions. A money market account may refer to a money market mutual fund, a bank money market deposit account (MMDA) or a brokerage sweep free credit balance.
Ultrashort bond funds are mutual funds, similar to money market funds, that, as the name implies, invest in bonds with extremely short maturities. Unlike money market funds, however, there are no restrictions on the quality of the investments they hold. Instead, ultrashort bond funds typically invest in riskier securities in order to increase their return. Since these high-risk securities can experience large swings in price or even default, ultrashort bond funds, unlike money market funds, do not seek to maintain a stable $1.00 NAV and may lose money or dip below the $1.00 mark in the short term.[17] Finally, because they invest in lower quality securities, ultrashort bond funds are more susceptible to adverse market conditions such as those brought on by the Financial crisis of 2007–2010.
Enhanced cash funds are bond funds similar to money market funds, in that they aim to provide liquidity and principal preservation, but which:[18]
Enhanced cash funds will typically invest some of their portfolio in the same assets as money market funds, but others in riskier, higher yielding, less liquid assets such as:[18]
In general, the NAV will stay close to $1, but is expected to fluctuate above and below, and will break the buck more often.[19][20][21] Different managers place different emphases on risk versus return in enhanced cash – some consider preservation of principal as paramount,[19] and thus take few risks, while others see these as more bond-like, and an opportunity to increase yield without necessarily preserving principal. These are typically available only to institutional investors, not retail investors.
The purpose of enhanced cash funds is not to replace money markets, but to fit in the continuum between cash and bonds – to provide a higher yielding investment for more permanent cash. That is, within one's asset allocation, one has a continuum between cash and long-term investments:
Enhanced cash funds were developed due to low spreads in traditional cash equivalents.[19]
There are also funds which are billed as "money market funds", but are not 2a-7 funds (do not meet the requirements of the rule).[18] In addition to 2a-7 eligible securities, these funds invest in Eurodollars and repos (repurchase agreements), which are similarly liquid and stable to 2a-7 eligible securities, but are not allowed under the regulations.