MONEY MARKET FUNDS EXPLAINED: YIELD, SAFETY, AND RISK

What Are Money Market Funds?

Money Market Funds (MMFs) are a type of mutual fund that invests in short-term debt instruments which are typically low in risk and provide modest returns. These funds are designed to offer liquidity, capital preservation, and a slightly higher yield compared to traditional savings accounts. MMFs are often used by individual investors, institutional investors, and corporations seeking a safe place to temporarily hold cash.

Typical investments found in a money market fund include U.S. Treasury bills, commercial paper, repurchase agreements (repos), and certificates of deposit (CDs). Due to the short maturity periods of these instruments—usually within 13 months or less—the value of the investments remains relatively stable.

Unlike bank savings accounts, MMFs are not insured by the FDIC. However, they are regulated under the Securities and Exchange Commission (SEC) in the U.S. and similarly regulated in the UK by the Financial Conduct Authority (FCA). Regulations require MMFs to maintain a high-quality and mature portfolio, contributing to their relatively low volatility.

There are three primary types of MMFs:

• Government Money Market Funds: Invest primarily in government-backed securities, such as Treasury bills and government repo agreements. These are generally considered the safest.
• Prime Money Market Funds: Include corporate debt such as commercial paper and are used primarily by institutional investors. They may offer slightly higher yields but come with slightly more credit risk.
• Municipal Money Market Funds: Focus on debt issued by municipalities and are typically exempt from certain taxes, which can be advantageous for investors in higher tax brackets.

These funds aim to maintain a stable net asset value (NAV) of £1.00 (or $1.00 in the U.S.) per share. This stability adds to the perception that they are a safe cash equivalent, though actual performance may fluctuate slightly.

How Do Money Market Funds Work?

Investors buy shares in money market funds similar to any mutual fund. The MMF manager then pools the invested money and allocates it across short-term debt instruments, aiming to achieve returns while minimising risk. Returns are generally distributed to shareholders in the form of dividends, typically on a daily or monthly basis.

One crucial feature of MMFs is liquidity. Investors can usually access their money relatively quickly, often with same-day or next-day availability. This makes MMFs especially useful for large institutions and corporate treasurers managing day-to-day cash needs without sacrificing yield.

In summary, MMFs offer the benefit of stability, modest earnings, and high liquidity. They are a powerful financial tool for those seeking an interim investment strategy focused on capital preservation and risk reduction.

How Do Money Market Yields Work?

The yield on a money market fund represents the rate of return an investor earns over a given period of time. It's often quoted as the 7-day SEC yield in the United States or as an annualised effective yield in other regions. These yields fluctuate based on short-term interest rates and the type of instruments held by the fund.

Key factors influencing MMF yields include:

• Interest Rates: Yields generally rise when central banks (like the Bank of England or the Federal Reserve) raise interest rates. Conversely, yields decline in a lower rate environment.
• Type of Assets: Government MMFs mostly contain low-yield assets, whereas prime MMFs may incorporate higher-yield, higher-risk assets like corporate paper.
• Fund Expenses: Management fees affect net returns. Although these fees are low (often under 0.50%), they still reduce the investor's total yield.

Investors often compare the yield to inflation to determine real return. If inflation is higher than the fund’s yield, the purchasing power of your money may still erode despite earning interest.

Comparing Money Market Yields

MMF yields can vary across funds, even those holding similar assets. That’s because various funds may:

• Have different expense ratios
• Use varying credit criteria for eligible debt instruments
• Include tax-exempt instruments (in municipal funds)
• Differ in liquidity mandates

It's also important to note that yield is not guaranteed. Despite their reputation for stability, MMFs are still investment vehicles and subject to some level of market dynamics, particularly in extraordinary market environments.

For example, during the 2008 financial crisis, a well-known MMF "broke the buck" — its NAV dropped below £1.00 per share — due to exposure to downgraded Lehman Brothers commercial paper. Though rare, such events highlight that yield pursuits should be balanced against risk tolerance.

How to Evaluate a Money Market Fund

When comparing MMFs, look at the following metrics:

• 7-day/30-day yield: Represents recent annualised yield performance
• Expense ratio: Lower is usually better
• Credit quality: Indicates how safe the underlying assets are
• Average maturity: Shorter periods suggest more liquidity and lower interest rate risk
• Historical NAV stability: Shows the fund’s ability to maintain a constant value

Ultimately, money market yields should be seen in the context of the broader financial goals. They aren’t designed for growth, but rather for stability, liquidity, and modest income.

What Does “Low Risk” Really Mean?

Money market funds are commonly labelled as "low risk," but that doesn't mean they are devoid of all risk. The term generally refers to the fund’s conservative investment strategy and regulatory requirements. These qualities make MMFs far less volatile than equity or bond funds, but not completely risk-free.

Types of Risks in Money Market Funds

Despite their low-risk image, money market funds are exposed to several specific risks:

• Credit Risk: The risk that an issuer of a debt security will default. Government MMFs have very low credit risk because they invest in government-backed securities. However, prime MMFs carry more exposure to private corporate debt.
• Interest Rate Risk: As interest rates rise, the market value of existing fixed-rate securities can decrease. MMFs manage this by keeping maturities short.
• Liquidity Risk: Shock events could make it difficult for the MMF to meet redemption requests, prompting the fund to implement fees, gates, or suspend withdrawals temporarily.
• Operational Risk: The risk of loss from failed processes, people, or systems within the fund management operation.
• Regulatory Risk: Changes in rules governing MMFs—such as liquidity requirements or NAV disclosures—could affect investor returns or fund operations.

Stress Events and Historical Precedents

Although rare, stress events demonstrate that even MMFs can encounter trouble. In the 2008 financial crisis, the Reserve Primary Fund became one of the first MMFs to fail to maintain its £1 NAV due to its exposure to Lehman Brothers. This led to a temporary investor panic and significant regulatory overhaul in the years that followed.

In March 2020, the COVID-19 pandemic sparked a rush for liquidity that significantly stressed market conditions. Several funds needed intervention and guarantees from central banks and monetary authorities to maintain stability.

Mitigating Risks as an Investor

Investors can take steps to minimise the remaining risks associated with MMFs by:

• Choosing government-only MMFs for maximum safety
• Regularly reviewing fund holdings and manager updates
• Balancing MMF allocations with other secure assets like savings or term deposits
• Staying aware of macroeconomic shifts and regulatory trends

It’s essential to assess how MMFs fit into your overall financial strategy. For short-term storage of cash or as a parking place for emergency funds, they make a strong case. However, for long-term financial growth, other investment vehicles may be better suited.

Regulatory Safeguards

To enhance investor confidence, regulators require MMFs to adhere to strict guidelines. In the EU and UK, new rules under European MMF reform laws (such as Regulation (EU) 2017/1131) define minimum liquidity levels, reporting requirements, and risk metrics. In the U.S., the SEC's Rule 2a-7 imposes comparable constraints.

These measures ensure MMFs remain diversified, transparent, and capable of withstanding short-term financial turbulence. Nevertheless, investors should continue to evaluate funds for stability, especially during times of economic uncertainty.