Money Market Funds: Benefits, Drawbacks, Regulations

US money market funds recently eclipsed $7 trillion in assets for the first time. For decades, investors have turned to this simple, conservative investment vehicle for cash management and capital preservation. And while the Fed eyes future interest rate cuts, Debbie Cunningham doesn’t see investor interest flagging anytime soon. 

Debbie is the chief investment officer of global liquidity markets at Federated Hermes. She joined the Big Picture in Practice podcast to discuss this humble, yet sizable corner of the asset management industry. 

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A money market fund invests in high-quality, short-term debt instruments, cash, and cash equivalents. Money market funds aim to provide current income that is consistent with capital preservation. Most money market funds offer a stable net asset value of $1 per share, distributing any excess returns as dividends to their shareholders. 

These funds often hold securities such as: 

• Certificates of deposit, or a financial product that pays an interest-rate premium on a lump-sum deposit left untouched for a set period. CDs are offered by banks and credit unions and insured by the FDIC. 

• Commercial paper, or short-term, unsecured corporate debt, usually sold at a discount to face value. 

• Corporate bonds. 

• US Treasury bills, or short-term debt backed by the US government. 

• Repurchase agreements, or short-term agreements to sell a security at one price and buy it back later at a higher price. These could include government debt, corporate debt, or equities. 

Morningstar organizes money market funds into four categories, based on their underlying securities and taxation status. 

• Taxable money market portfolios invest in short-term money market securities. These funds designate themselves as Government or Single State in Form N-MFP. 

• Prime money market portfolios invest in short-term corporate and bank debt securities. These funds designate themselves as Prime in Form N-MFP. 

• Tax-free money market portfolios invest in short-term municipal debt securities that are often exempt from some federal and state taxes.  

• Non-40 Act money market portfolios invest in short-term money market securities. These funds are not subject to 2a-7 regulations under the Investment Company Act of 1940. Morningstar only uses this category in our custom fund, separate account, and collective investment trust databases. 

Debbie has been with Federated Hermes since her college graduation, seeing the industry’s evolution firsthand. 

Money market funds debuted in 1973 and were just coming of age when interest rates neared 20% in the 1980s. Retail investors flocked to the product for its stable value and income returns. 

Even when interest rates stabilized, Debbie says that money market funds remained popular because there were few competing vehicles for capital preservation. Retail investors could buy the underlying securities directly, but not in practical denominations. Investors also had access to long-term fixed-income funds, but those came with the potential for negative returns. 

“If you had to sell the security that you owned at an earlier date, you had the potential for price appreciation or depreciation,” Debbie says.  

The growth in the category persisted until the 2008 financial crisis. When Lehman Brothers defaulted, only one fund in the money market industry owned Lehman paper. That fund couldn’t maintain $1 stable net asset value with daily liquidity. Banking regulators were concerned about a potential bank run and mass redemptions that weekend. 

Debbie, a proud Penn State fan had planned to watch her football team play in Happy Valley that Saturday. She spent the tailgate working from the Beaver Stadium parking lot, partnering with other industry players to formulate the $1 NAV insurance that was then applied to money market funds for the next two years. 

“I basically locked myself in the bathroom of the RV so I wasn’t disturbed,” she remembers. “With 300,000 extra people in very small college town, cell service wasn’t the best—but it worked out.”   

Money market funds have faced persistent, near-existential regulatory threats from day one. The SEC, not the banking regulators, has regulated money market funds since the 1980s. Rule 2a7, the section of the 40 Act that governs how money markets are regulated, has gone through six major rewrites since its inception. 

Money market funds face an expansive and ever-changing competitive set, from cash under the mattress to short-term fixed-income ETFs. Debbie says that the reason they’ve maintained their popularity is their simplicity and ease of use. 

Benefits of money market funds include: 

• Diversification. Money market funds give investors access to securities across issuers and industries. 

• Daily liquidity. To ensure that investors can quickly access funds, money market funds hold a significant portion of their assets in overnight securities. 

• Low duration and credit risk. Money market funds are generally restricted to holding shorter-term, higher-quality debt instruments. This means they invest in securities that are less likely to default. 

• Stable value. Money market funds are designed to maintain stable net asset values, which helps investors preserve capital. This predictability makes money market funds a reliable place for investors to park their cash without worrying about fluctuations in value. 

Money market funds also come with risks worth considering when determining their place in a portfolio. 

• Interest rate sensitivity. The yields of money market funds tend to track the market interest rates associated with their underlying holdings. When interest rates fall, yield often falls as well. 

• Opportunity cost. Money market funds are built for capital preservation over appreciation. Overallocation to these funds could cause investors to miss out on growth in other, riskier segments of the market.

Even as money market funds hit new AUM highs, Debbie says Federated Hermes isn’t resting on its laurels. She’s interested in exploring new ways of packaging, distributing, and consuming money market funds that could go further to support investor needs. 

“You can be innovative, yet conservative, which is what’s required for money market investors,” Debbie says. 

She points to exchange-traded funds, which could use collateral to back up their value and expand access to investments beyond direct securities. Through tokenization, money market funds could be distributed on the blockchain. One day, digital assets could support the flow of funds across time zones and the 24-hour clock, with different currencies all embedded in the same product. 

Recently, brokerage firms have drawn regulatory ire for defaulting uninvested client cash in low-yield sweep accounts. These products aren’t market based, which lowers the risk, but also offers lower yields and returns at a time when short-term money-market rates are much higher. The default choice puts the burden on the client to understand their options and move their money into another vehicle. 

That set-and-forget attitude might work to the detriment of investors, coming at the cost of missing out on interest for those cash balances. Advisors should look beyond the default and educate clients on other places to put their cash.