What is a “Money Market Fund”?
A money market fund is a low-risk collective investment that provides exposure to highly liquid cash or cash equivalent securities such as short-term debt. They are invested in instruments that are characterized with short maturities and very low credit risk such as short-term corporate bonds, commercial paper, and overnight bank deposits. This type of fund could be used as a risk management tool in a diversified portfolio. It is suitable for investors with a short-term investment horizon, very low-risk appetite, and high liquidity requirements. Money market funds can be also utilized as a cash alternative or holding place for assets while waiting for more attractive opportunities to arise.
Key Learning Points
- Money market funds are typically structured as mutual funds that offer exposure to very low-risk cash or high-quality cash equivalent securities such as short-term debt
- Examples of typical underlying holdings include short-term government or corporate bonds, commercial paper and overnight bank deposits
- Investors use them for risk management purposes or as cash alternatives due to their high liquidity – a convenient and efficient place to hold cash until better opportunities arise
- These funds offer some income (usually dividends) but very little capital growth – investors can expect a total return in excess of that offered by typical deposit accounts
The Basics of Money Market Funds
Money market funds tend to offer well-diversified portfolios, invest only in high-quality and liquid instruments and aim to reduce uncertainty by keeping their time horizon short. With a typical duration of just a few months, they are exposed to less interest rate risk relative to longer-duration fixed-income investments.
Like any other mutual fund, they are priced and issue and redeem shares on a daily basis so investors have easy and relatively quick (but not instant) access to their funds. Money market funds can be a good fit for investors seeking cash-like instruments that provide small returns for very low risk. In addition, due to the stability and near-term time frame these strategies offer, some investors may also use them as an emergency fund or place to hold cash temporarily.
How to Use Them in a Portfolio?
From a portfolio management perspective, money market funds could be utilized as a risk management tool that might bring the overall volatility of the portfolio down. They can also offer diversification benefits. Money market funds typically hold a large number of different securities and show a low correlation to other asset classes. However, considering the low level of risk and the capital preservation features of the money market strategies, investors should not expect high returns on their investment.
What Are the Risks?
Despite ranking as a relatively safe investment compared to other major asset classes (such as bonds and equities), money market funds are still exposed to some degree of credit risk. Although unlikely, the risk of default in the underlying constituents is still possible.
Money market funds are not suitable for building wealth over the long term and could underperform in an inflationary environment, alongside longer duration bond peers. Although unlikely, some money market funds may impose liquidity fees in order to prevent large redemptions or even temporary suspension during periods of extreme market volatility.