Money Market Mutual Funds

In the previous articles, we have seen the various types of financial instruments which are deployed by different players in the money market.

Almost all types of financial instruments are issued in a high denomination. This is the reason that very few individual buyers can actually afford to invest directly in these funds.

However, the retail investors do have a significant amount of money that is lying around in their accounts and can be used for short-term borrowing which is characteristic of the money market funds.

Hence, in order to facilitate the investment by individual buyers into the money market, money market mutual funds were created.

In this article, we will have a closer look at what these funds are and how they operate.

What are Money Market Funds?

Money market funds are like mutual funds which buy large amounts of money market securities. They fund the purchase of these securities by issuing their own securities which are purchased by other investors.

Theoretically, all types of institutional investors such as insurance funds and pension funds can also invest in the money market mutual funds. However, in reality, most of the investment in these funds is made by individuals. Money market funds are very important since they allow retail investors to have access to the money market.

Types of Money Market Funds

Money market funds can be characterized into different types based on different characteristics. However, in most parts of the world, these funds are characterized into taxable and non-taxable types.

1. Taxable money market funds are those funds that invest most of their money in securities where the investor has to pay a tax on the return. For instance, if an investor invests $100 in treasury bills or commercial paper and earns $5 from this investment, then they have to pay taxes on the $5 income. Depending upon the specific financial instrument, they may have to pay federal taxes only, or federal as well as state income taxes may have to be paid.

2. Non-taxable money market funds are those which invest their funds in assets that are non-taxable. There are a lot of municipal, infrastructure, and other government securities in the money market which have special tax waivers. These funds focus exclusively on generating returns by investing in securities that are not taxable.

Taxable as well as non-taxable money market mutual funds are usually segregated because they attract different kinds of investors.

Non-taxable mutual funds generally attract investors who fall in the highest tax bracket. This is because even if the nominal return of these securities is lower, the fact that they are tax-free makes their real rate of return higher for people who fall in the higher tax bracket. Hence, people with higher incomes tend to prefer non-taxable money market mutual funds over taxable mutual funds.

How do Money Market Funds Operate?

1. It is important to note that most money market funds do not have any entry fee or exit fee. This is done in order to ensure that investors are able to enter and exit without any loss of value due to transaction charges. However, just like every other mutual fund, there are certain costs that are associated with money market mutual funds. These costs are generally deducted from the return generated by the fund. Hence, there are no explicit costs that investors have to pay in order to invest in these funds.

2. The management charges on money market mutual funds which have more assets under management tend to be lower. This is because there are economies of scale at play. Hence, investors tend to avoid funds that have fewer assets under management.

   In order to encourage investors to invest in their fund, smaller funds tend to waive off their management fee either partially or completely till the fund gains a significant number of investors. Even though the fee does not have to be explicitly paid by the investor, it ends up reducing their rate of return. Hence, it would be advisable for investors to compare expense ratios of different funds before investing in one.

3. Money market mutual funds tend to be highly liquid. Investors can easily withdraw their money by asking the mutual fund to redeem their units. Some funds also allow their investors to issue checks based on their funds in the money market mutual fund account. However, these checks must have a minimum value.

4. It is important to know that money market mutual funds provide daily returns to their investors. This is because their accounting policies are set in such a way that they record their purchases at the face value. If there is any discount received while purchasing the security, it is not immediately passed on to the investor.

   Instead, any growth in investment is evenly spread out across the entire maturity of the underlying instrument. This is done to ensure that the prices of money market funds are not volatile.

   The management of the mutual fund provides a daily dividend on a pro-rata basis so that the returns are evenly distributed amongst investors based on the length of time that they choose to remain invested in a firm.

It can be said that money market mutual funds are the most critical money market financial vehicle from the point of point of view of the retail investor.

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