What is a Money Market Fund?

Money Market Funds (MMFs) are open-ended investment vehicles (or ‘mutual funds’). They aim to offer a cash-like alternative, which can provide potential advantages, such as competitive yields. Like other mutual funds, the investor is considered a shareholder or unit holder of the total investment pool.

MMFs invest in only the highest credit quality issuers and instruments. The MMF itself may have a credit rating, which provides the investment framework for the investment manager to adhere to.

In Europe, MMFs are regulated by the European Securities and Markets Authority (ESMA). There are three types of MMFs that fall under ESMA’s regulation: Public Debt MMFs, Short Term MMFs and Standard MMFs.

What are the benefits of a MMF?

Compared to leaving cash balances with a small number of financial institutions, security is improved through superior diversification. A MMF has numerous underlying holdings, which can comprise 50 to 100+ differing line items. There is a dedicated team of investment professionals, which include credit analysts who ensure the diversification consists of the highest credit quality issuers with assigned duration limits (3) . One of the analysts’ key responsibilities is to create and manage the approved buy list for the portfolio manager.

A AAA rated Short Term MMF can only invest in instruments with a minimum credit quality, for example, equivalent to A1/P1/F1 (i.e. a ‘superior’ credit rating [4]. Therefore, for a AAA rated Short Term MMF, it is the eligible A1/P1/F1 universe that would be reviewed to reduce down to the approved buy list. The fund will have weighted average maximum maturity of 60 days and a maximum individual duration of 397 days.

Liquidity is another potential benefit. Dependent upon the MMF, investors can access the fund daily or with a settlement period of T+1, for example. Yet underlying durations are up to 397 days in the example of the Short Term MMF. The investment framework ensures that security and liquidity are priorities, with yield as the output of strategy.

Obviously, with average durations of less than 60 days, depending on the MMF, it would be expected that a share of the total investment pool’s yield would be competitive. A Short Term MMF has shorter underlying durations than a Standard MMF, so it is important for the investor to review the MMF carefully to determine which would suit their investment profile requirements.

MMFs in rising or falling rate environments

Firstly, a MMF invests along the money market or yield curve (5)  and will be competitive relative to the central bank (‘base’) interest rate. Potential interest rate movements are priced into these curves. In a declining rates environment, the MMF’s portfolio manager will be investing in longer underlying durations leading up to the potential interest rate cuts.

Using a Short Term MMF as an example, you would expect to see the weighted average duration (in days) to be in the late 40s to 50s. This optimises the lag effect after an interest rate cut, whereby it will take time for the MMF yield to reduce down to the new, lower levels. Vice-versa, in a rising rates environment, you would expect the weighted average duration (in days) to be lower – in the 20s or 30s, for example – as this optimises the lag effect to catch up with the new, higher interest rate movement.

The speed of the lag effect can also be influenced by cash flows – in other words, whether net inflows or outflows are being received after a rate movement. Net cash inflows will reduce the lag effect, which is otherwise a matter of days anyway, depending on the type of MMF.

Could investors use MMFs to substitute their existing cash investment strategy?

MMFs are a potentially useful investment vehicle for investors with surplus cash. It is up to the investor to make their decision according to what suits their profile and to decide whether to use a MMF in a complementary fashion to an existing strategy, or to use the MMF as a substitute to replace their existing strategy. 

Any other considerations?

Due to there being various types of MMFs available, it is important to review a fund’s documentation carefully. There are underlying differences in Public Debt MMFs, Short Term MMFs and Standard MMFs, which could potentially include the use of derivatives(6); however, these instruments are not widely used except by certain fund managers or types of MMF. 

Another consideration is whether the fund is classified as constant, low volatility or variable net asset value (CNAV, LVNAV or VNAV respectively). An investor may prefer the stability of a Short Term LVNAV or Public Debt CNAV MMF, whereby the fund’s share value is maintained at £1/€1/$1(7) . However, if the VNAV Standard MMF (which is marked to market) is on a positive trajectory, this may lead to a superior return. This is a balancing act as the investor needs to decide whether to pursue or compromise on yield, liquidity or both. 

Finally, there are also choices around interest accrual. In terms of frequency, this could be daily or monthly. Interest could take the form of a dividend or be paid back into the MMF account. Alternatively, the interest may roll up daily.