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Money market funds: Balancing safety and liquidity
Investing may feel like you're always searching for the next great TV show to binge. Sometimes, you have to choose between a series option with a multi-season commitment or a favourite flick you can re-visit while you wait for something that catches your eye.
Money market funds can at times feel like that familiar film: They may not have the long-term growth potential of stocks or bonds, but they are considered a stable alternative that offers regular income generation. In this way, money market funds may be viewed as a place to park money while searching for other investment opportunities, or as a place to keep savings that may be needed in the near future, like an upcoming vacation.
For these reasons, money market funds may seem similar to high-interest savings accounts, but with a few important differences.
What is a money market fund and why is it important?
A money market (or cash equivalent) fund is a type of mutual fund that makes short-term investments in a range of highly liquid, low-risk debt securities, such as cash funds, treasury bills and bonds. In Canada, these funds must invest at least 95% of their assets in Canadian-dollar debt securities with maturities of less than a year1. Money market funds appeal to investors who want to earn fixed interest while protecting their capital. The funds can be popular in high-interest environments because they provide a steady stream of investment income, typically with less volatility than you might see from stocks or bonds.
A brief history of money market funds
Money market funds were created in the early 1970s to offer investors exposure to a pool of securities that generally provide greater returns than high-interest savings accounts. Unlike mutual funds, which aim for asset growth, money market funds target a stable net asset value (NAV) — usually $1 or $10 in Canada — with any excess earnings dispersed to investors in the form of monthly dividend payments.
Money market funds only held government bonds when they were introduced. Today, they may also hold commercial paper, a form of short-term debt issued by companies. The aim of broadening out the holdings was to increase the potential for higher yields, though it also increases the chance they might lose money.
It’s rare for money market funds to lose money, though that happened in 2008 during the Reserve Primary Fund Crisis in the United States. During that time, the NAV on money market funds fell — an occurrence known as “breaking the buck.” The event led to changes in how money market funds operate in the United States.
Another steep outflow of cash from money market funds — in March 2020, at the start of the pandemic — prompted further regulatory changes in the United States in 20232. This included the introduction of a liquidity fee that may be charged to investors holding U.S. money market funds if a fund’s weekly liquid assets drop below a certain level. The changes also provided tools to help non-government money funds address future runs and decrease the likelihood of another broken buck.
Money market funds have evolved into a key component of today’s markets, offering investors a low-risk fixed-income option with high liquidity. As interest rates rise, so does their popularity among investors, who generally use them as a short-term place to invest money while they consider other options or save for near-term goals.
Significance of money market funds
Money market funds allow savers to lend their excess cash to businesses and governments that need short-term loans in exchange for a small return. This can provide critical liquidity to the economy as well as help investors smooth out the returns in their portfolios.
Characteristics of money market funds
Investment objectives
Money market funds are fixed-income investments that offer low-risk exposure to high-quality debt securities. They may not have the same return potential as other mutual funds, but they can limit volatility and protect your money while still providing a steady stream of interest.
Liquidity
The highly liquid nature of money market funds is part of their appeal. They can be easily exchanged for cash with a few days’ notice.
Safety and security
Money market funds are not covered by the Canada Deposit Insurance Corporation (CDIC) the same way a high-interest savings account would be. That means your investment would not be protected in the rare instance a member financial institution fails. Because of their conservative nature, however, they are generally considered to be a very low-risk investment.
Diversification
Money market funds can be a key part of a diversified portfolio because they provide a low-risk way to protect capital while generating interest. Investors may aim to limit volatility and smooth out the returns in their portfolio by allocating a portion of their fixed-income holdings to money market funds.
Types of assets held
Depending on the specific goals of a particular money market fund, holdings can include:
- Federal or provincial bonds or notes: Interest-paying securities issued by governments to raise capital for operations or special projects.
- Commercial paper: Short-term debt issued by companies to pay immediate liabilities.
- Bankers’ acceptances: A bit like a post-dated cheque, these are guarantees of a future payment issued by a bank.
- Treasury bills: Short-term securities supported by the U.S. government.
How do money market funds work?
Investment process
Money market funds operate much like other mutual funds. When you buy units, the fund invests your money to purchase short-term corporate, bank or government debt.
Portfolio management
Some money market funds are professionally managed and charge fees, which can lower your overall returns.
Returns and yields
Money market fund yields have varied significantly over the years. Over the past 20 years, yields have ranged from between almost 0% to slightly north of 5%. Yields were particularly low from 2009 to 2010 and again from 2020 to 2021, during the COVID-19 pandemic3.
Redemption and liquidity options
Money market funds are highly liquid, making it easy for investors to access their money with just a few days’ notice. However, it’s important to note that for U.S.-based funds, if their weekly liquid assets drop below a certain level, investors may be charged a liquidity fee of around 2% on withdrawals.
Tax considerations
You can typically expect to pay taxes on the dividends you receive from money market funds that are held in a non-registered account, such as cash and margin accounts.
Types of money market funds
Prime money fund
Prime money market funds primarily invest in taxable, short-term obligations issued by banks and corporations.
Government money fund
These funds have almost all their assets invested in government securities, cash and repurchase agreements.
Treasury fund
Treasury funds invest the bulk of their assets in U.S. Treasury-issued debt securities, such as Treasury notes and bonds.
Tax-exempt (or municipal) money fund
Tax-exempt money market funds, which are available to U.S. investors, may help qualified investors avoid government taxation, depending the underlying securities
Disadvantages of money market funds
- They aren’t insured: Money market funds are not eligible for CDIC coverage, so the money you’ve invested in a money market fund will not be protected in the rare event of a bank failure.
- There’s no capital appreciation: Money market funds are considered effective at preserving capital, not growing it.
- Returns are not guaranteed: Although it’s rare, money market funds can still lose money.
- You may have to pay fees: Some money markets funds are professionally managed and carry fees that can lower your returns. Be sure to research the specifics of any fund of interest before investing.
Difference between money market funds and mutual funds
Money market funds are basically the same as mutual funds except for the fact that they target a specific net asset value (usually $1 or $10). Any monthly earnings above this NAV are distributed to investors in the form of dividend payments. The NAV requirement generally ensures a steady stream of income while making it easy to track how a fund is performing.
Investing in money market funds
How to invest in money market funds
Money market funds, often referred to as cash equivalent funds in Canada, can be purchased through an online brokerage account, such as TD Direct Investing.
When to invest in money market funds?
Money market funds can be an attractive option in high-interest rate environments, for anyone who is saving for short-term goals or biding their time while mulling other opportunities.
Special Considerations
SEC regulations
Under U.S. Securities and Exchange Commission (SEC) provisions, U.S. money market funds are required to primarily invest in top-rated debt instruments and should have a maturity period that does not exceed 13 months. A fund’s portfolio must also maintain a weighted average maturity period of 60 days or less to ensure that only highly liquid debt instruments are included. This aims to prevent investor money from losing liquidity by being tied up in instruments with longer maturities. Money market funds are also prohibited from investing more than 5% of their capital with any one issuer, although repurchase agreements and government-issued assets can be exempt from this stipulation.
Role of credit rating agencies
Credit rating agencies can be invaluable when deciding where to park your money because they consider a unique set of criteria that is specific to money market funds. This can include an assessment of the composition of a portfolio, the quality of the assets it contains and the operational and legal framework that governs it. Credit rating agencies also evaluate each fund on its ability to preserve investor funds and provide liquidity.
Recent regulatory changes
In July 2023, the SEC implemented a change that requires U.S. money market funds to charge a mandatory liquidity fee if their daily net redemptions exceed 5% of the fund’s net assets (unless their liquidity costs are negligible). This move was intended to make it less likely that investors will rapidly withdraw their funds in times of economic uncertainty.
FAQs
Are money market funds low risk investments?
Money market funds are considered very low risk because they deal in high-quality, highly liquid assets. Although they are not insured by the CDIC, they are considered a low-risk investment to store your savings because they’ve rarely lost money.
How do money market funds differ from savings accounts?
Money market funds are a type of mutual fund that invests in low-risk securities while striving to achieve a net asset value (often $1 or $10 per share) before paying out interest as dividends. They tend to have higher yields and no limit on monthly withdrawals, but are not covered by the CDIC and can be subject to management fees. Savings accounts, on the other hand, include CDIC insurance and have no management fees, but often carry lower interest rates and limit the number of monthly withdrawals.
What is the typical minimum investment requirement for money market funds?
The minimum investment on money market funds in Canada can range from $100 all the way to $5,000, although subsequent investments can be lower.
Do money market funds provide competitive returns?
Money market funds can be an attractive option for short-term investors in high-interest environments, but the returns may not be as attractive as what you might get from another type of investment like a mutual fund, exchange-traded fund or other low-risk investments like a guaranteed investment certificate.
How liquid are money market funds?
Money market funds are highly liquid by nature, making it easy for investors to withdraw their money in a matter of days.
How often do money market funds pay dividends?
Money market funds generally pay out dividends on a monthly basis.
Can I use money market funds as a part of my emergency fund?
The highly liquid, low-risk nature of money market funds make them suitable for an emergency fund. Their stated aim is to preserve capital and provide regular interest payments.
What are the fees associated with money market funds?
Depending on the exact nature of the fund, investors can expect to pay management fees and, in rare economically turbulent cases, a liquidity fee upon withdrawal of money.
Is there a difference between a money market fund and a money market account?
Yes. A money market fund is an investment that you buy or sell that does not include insurance on your principal. A money market account is a type of interest-earning savings account offered to businesses in Canada (they are not available to individual investors, as they are in the United States). Another key difference is the yield: Money market funds offer a fixed rate, whereas money market accounts provide a variable yield.
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