Personal Finance: The basics of money market funds

Personal Finance: The basics of money market funds

December 6th, 2017 by Christopher Hopkins in Business Diary

Christopher Hopkins

Christopher Hopkins

Photo by Contributed Photo /Times Free Press.

Money market funds are perhaps the most widely held class of investment vehicle, with assets in excess of $3 trillion in the United States.

Yet most investors know relatively little about how they are constructed and managed. Today, in another installment of our occasional series on investment securities, we take a look at these popular repositories for idle cash.

Before the 1970s, cash balances languished in low-yielding bank or brokerage accounts while awaiting redeployment into another investment. In 1971, the brokerage industry created a particular variety of open-ended mutual fund specifically tailored to attract short-term cash balances. Unlike bank accounts, whose interest rates represented the cost of deposit capital for lending, money market funds invested their customers' funds into other interest-bearing instruments like U.S. Treasury bills, generating a higher return and attracting deposits away from some traditional banks. Owing to their structure, these funds were outside the regulatory jurisdiction of the FDIC and were therefore technically uninsured, although they were generally considered an extremely low risk alternative.

In response, a 1983 banking reform bill opened the door for banks to offer their own, FDIC-insured versions of money market funds to compete with the brokerage firms. Many accounts have a so-called "sweep" feature that automatically transfers or sweeps excess cash into a money fund at the end of each business day.

Over time, a large variety of money funds has developed offering investors a panoply of options regarding taxation, yield and relative risk. As noted above, early offerings generally stuck to good old U.S. Treasuries, but soon additional iterations began to appear as demand for these vehicles ballooned. In addition to government bond funds, investors may now select tax-advantaged or tax-free money funds comprised of municipal bond investments. Another class often called "prime" funds include very short-term bonds of corporations and foreign governments. Meanwhile, investors seeking higher yields can venture into slightly riskier funds that purchase bonds with longer maturities or lower credit ratings.

Bear in mind that the range of potential returns among these funds is relatively narrow, as they are all intended to serve as a parking place for uninvested cash. Most brokerages specify a default selection of money fund, often a version offered by a banking affiliate. You must make an affirmative decision to seek out a higher-yielding alternative, and may have to place an order to purchase the shares instead of enjoying an automatic sweep.

Most money market funds are constructed very much like most open-ended mutual fund with one important exception: the funds typically attempt to peg the price of shares at $1, so that the share balance corresponds with the dollar balance at any given time. This was not a legal requirement, but a practical one: investors aren't too keen on the prospect of losing money in what they consider a safe stash.

During the 2008 financial crisis, the calm waters were roiled when a prominent fund company lost money on the investments in the fund and allowed the value of its shares to dip below the $1 level. Clearly, few investors actually knew their fund shares could "break the buck," and since the crisis regulators have added some safeguards. Additional liquidity (ready cash in the fund) is now required in versions offered to retail investors, and fund sponsors have the power to impose redemption limits and fees in time of extreme stress. These measures are all aimed at stabilization should another panic erupt.

Money market funds have become widely accepted as a convenient and (slightly) higher-yielding alternative to traditional bank deposits. Given their ubiquity, it is important to know the basics.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.

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