According to the mutual fund industry trade group Investment Company Institute, continued upheavals in the banking industry and the unsettled economy have caused over $30.28 billion to flow into money market funds, or MMFs, in the week ending Wednesday, April 12. This has pushed total money market fund assets to $5.28 trillion, the largest number since the $4.8 trillion pandemic peak.
MMFs invest in short-term assets and securities such as cash, cash equivalents and highly liquid, near-term instruments.
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U.S. Treasury and government securities MMFs includes investments such as:
— U.S. Treasurys
— Repurchase agreements (short-term government securities)
— Certificates of deposit
Prime MMFs generally offer an advantage in yield due to their investments in:
— Bank acceptances (short-term debt guaranteed by commercial banks)
— Commercial paper (unsecured short-term corporate debt)
MMFs are designed to generate higher yields than bank savings accounts or money market savings accounts. They are most suitable for investors who are seeking to preserve capital, maintain liquidity and earn dividend income. Thus, if an individual wants to invest funds that they know they will need in a short time span, a money market fund could be a viable option.
MMFs generate income, but little to no capital appreciation. As a result, MMFs are not considered suitable for long-term investments, but rather as a short-term place to park cash.
The income generated can be taxable or tax-free depending on the underlying investments. A fund distributes excess earnings from interest as dividends. Investors like MMFs because the fund managers have to make regular payments to the investors, which allows for a steady stream of income.
History of Money Market Funds
MMFs have been around since the early 1970s. In 1970, Bruce Bent and Henry Brown established the first MMF called the Reserve Primary Fund. Considered a low-risk investment, MMFs gained traction because of their stated goal of maintaining a net asset value, or NAV, of $1 per share. This enabled smaller investors to have a safe place to park cash in the short term, while earning a higher return on their investments than they would with interest-bearing bank accounts.
Since the early success of the Reserve Primary Fund, MMFs have been considered safe havens in times of market volatility. Nearly every 401(k) plan in the nation includes money market funds in the cash category, sometimes as the only cash option available.
Breaking the Buck
MMFs were started with the premise that the NAV would remain constant at $1 per share. If the NAV went below $1, it was referred to as “breaking the buck.”
Breaking the buck can occur when:
— Interest rates are too low for the fund to cover operating expenses or losses.
— Underlying investment values fall.
— Leverage is used, introducing new capital risk.
— Too many investors attempt to withdraw funds too quickly.
Since inception, the first incident of breaking the buck occurred in 1994 when the Community Bankers U.S. Government Money Market Fund was liquidated because of large losses in derivatives. The Investment Company Institute noted that, while this was the very first case of a fund breaking the buck, investors still received 96 cents of every dollar invested. This result generally appeased the public in terms of acceptable losses.
No additional incidents occurred until 2008, and the very first money market fund was gravely impacted. Investors in the Reserve Primary Fund were rattled to learn that the fund had $785 million in Lehman Brothers commercial paper. While this only represented about 1.5% of their total holdings, the intense media coverage of Lehman’s corporate bankruptcy created conditions causing the fund’s NAV to fall to 97 cents per share. As the financial markets melted down, fund managers announced that customers might lose money. This created a significant run on assets, which ultimately caused regulators to force the venerable fund to close its doors. As MMFs have grown significantly in size and importance in retirement plans, institutional investors and corporations make up the bulk of investors. This is because the slightly higher rate offered, especially in prime MMF funds, can represent millions of dollars to large investors. Additionally, MMFs tend to have fewer restrictions on withdrawals, adding to their liquidity value.
In 2020, short-term interest rates were driven to nearly zero to combat the global COVID-19 pandemic. This caused many MMFs to change strategy in order to avoid closing down, which they accomplished through strategies like waiving fees in order to hold yields above zero. The most controversial action taken was to offer negative yields, where investors actually paid for the privilege of the fund holding their money. Unfortunately, some funds still had to close their doors.
Risks and Protections
It is important to understand that money market funds are generally considered to be safe investments, but safe does not mean that they are risk-free. Therefore, understanding the pros and cons of any investment takes on a special importance with MMFs.
Unlike money market savings accounts offered by banks, MMFs do not offer Federal Deposit Insurance Corp., or FDIC, protection. Thus investors, while they can typically expect a slightly higher return, are taking an additional risk, since funds are not insured against losses.
However, money market funds are no longer legally required to keep their NAV share prices at or above a dollar. They also do not have to immediately redeem investor shares. Prime MMFs may charge liquidity fees and redemption fees for withdrawals. Additionally, when a money market fund waives fees in order to keep yields high, they are entitled to recoup these losses at a future date.
Past incidents of breaking the buck prompted the Securities and Exchange Commission (SEC) to create new regulations to better protect potential investors:
— In 2010, the SEC issued a series of new rules to provide more stability and resilience to managing risks.
— In 2016, the SEC allowed the NAV to float, meaning that it was allowed to go both above and below $1 per share. This gave funds more latitude to deal with adverse conditions without generating a run on funds. However, retail and U.S. government MMFs are still required to maintain the $1 per share NAV standard.
The SEC continues to weigh additional provisions that would require, among many proposals, that stable NAV funds could convert to a floating NAV if future market conditions warranted it to avoid negative fund yields.
Future Growth
Money market funds will continue to be in the news, both due to their popularity in the current market environment, but also because the Biden administration is actively promoting environmental, social and governance, or ESG, factors in these accounts.
ESG is a framework of criteria that corporations can use to evaluate their sustainability. While most ESG efforts are focused on long-term measures such as climate change, executive compensation and diversity initiatives, ESG is finding additional space within the short-term horizons embraced by MMFs.
Advocates claim that companies with better ESG characteristics correspond to better credit ratings, which can mitigate risk in the underlying MMF investments. Additionally, ESG-linked commercial paper is becoming more available, which will create new opportunities for socially minded investors and fund managers.
Proper Understanding Is Key
Money market funds’ chief competitive advantage is to offer what is historically considered a short-term haven for liquid assets to combat market volatility and generate steady income. It is possible to lose money in these investments and those losses are not backstopped by FDIC protections.
Thus, all investors should be sure to read the fine print. Additionally, many people would find the services of a professional financial planner invaluable to avoid emotional investment decisions, especially when the markets are moving quickly in response to global conditions.
[SEE: 6 Low-Risk Investments With Steady Returns for Retirees]
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Money Market Funds: What Are They and How Do They Work? originally appeared on usnews.com
