Are money market funds really ‘safe’? The risks investors can miss
Editorial staff, J.P. Morgan Wealth Management
- Money market funds hold high-quality investments designed to maintain a stable net asset value (NAV) of $1 per share, making them one of the lower-risk options available to investors. But lower risk isn’t the same as no risk.
- The risks investors can overlook include credit risk, liquidity risk and the fact that money market funds do not come with FDIC insurance like cash management accounts at banks.
- Understanding the differences between fund types, reading the fine print on fees and withdrawal restrictions, and diversifying your cash holdings can go a long way toward managing money market fund risks wisely.
If you’re an investor looking to move part of your portfolio to low-risk investments, money market funds can be a sound choice. They’re used by millions of investors for everything from holding emergency funds to managing short-term savings between investments. The reputation these funds have earned as a safe investment has been built over several decades, largely due to their attractive risk-return profile.
But there’s a difference between “safe” and “risk-free.” Money market funds are not bank deposit accounts (money market accounts are completely different). They are not insured by the Federal Deposit Insurance Corporation (FDIC), and history has shown they can run into trouble when markets get stressed. It’s important to understand where the risks lie and how to manage them before opening a money market fund.
Money market funds, explained
A money market fund is a type of mutual fund that pools investor money and invests it in short-term, high-quality debt instruments. The goal is to preserve capital while earning a modest yield, making these funds useful for managing cash, maintaining liquidity and generating returns slightly higher than a traditional savings account.
Main types of money market funds
- Government money market funds invest at least 99.5% of their assets in cash, U.S. government securities or fully collateralized repurchase agreements.
- Prime money market funds invest in a broader mix of short-term debt, including bank and corporate paper, which gives them slightly higher yield potential but also modestly higher risk.
- Municipal money market funds invest in short-term state and local government securities and are often used by investors seeking tax-advantaged income.
The stable $1 NAV and what it takes to maintain it
Money market funds aim to maintain a stable $1 net asset value (NAV), offering a consistent principal value compared with fluctuating stock or bond investments. Due to this focus on stability, investors often utilize these funds as a secure alternative for “sideline” cash or as temporary holding spots.
To maintain that stable share price, money market funds must comply with Securities and Exchange Commission (SEC) Rule 2a-7, which limits them to very high-quality, very short-term investments and requires regular stress testing, diversification across issuers and minimum liquidity standards. After the panic witnessed during the 2008 financial crisis, the SEC implemented several rounds of reforms to reduce interest rate, credit and liquidity risk, and to increase transparency for investors.
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The money market fund risks investors can miss
Credit risk
Even the highest-quality investments can default under the wrong conditions. When a money market fund holds commercial paper from a bank or corporation that goes bankrupt, the value of those holdings can drop, which can negatively affect the fund’s NAV. While rare, it can happen, like when it did in 2008.
Liquidity risk
Money market funds depend on being able to sell their holdings quickly to meet investor redemptions. Under normal conditions, this isn’t a problem. But during a financial crisis, short-term credit markets can freeze up. Unfortunately, this is often when investors try to access their money.
Interest rate risk
Money market funds put your money into high-quality, short-term debt securities, such as U.S. Treasury bills and corporate IOUs – otherwise known as commercial paper – typically with maturities of less than a year. While this helps limit their sensitivity to rate changes, it doesn’t eliminate it.
When interest rates rise quickly, fund yields often lag, and the value of existing holdings can slip. When rates fall to near zero, fund managers may waive fees to keep returns positive. This, in turn, compresses any income advantage the fund offers.
‘Breaking the buck’ and what it actually means
If a money market fund’s NAV drops below $1 per share, it’s known as “breaking the buck.” It’s a rare event, but not an impossible one.
A notable example happened in September 2008, when the Reserve Primary Fund – then the world’s third-largest money market fund, with $62.5 billion in assets – dropped to 97 cents per share following the bankruptcy of Lehman Brothers.
Within days, investors pulled more than $300 billion out of prime money market funds across the industry – not just from the Reserve Primary Fund, but from funds that hadn’t lost a dollar, because fear can often spread faster than information.
Sponsor support risk: The backstop you can’t count on
Within the money market fund industry, the financial institutions that create, manage and promote these funds are known as sponsors. In normal market environments, money market fund sponsors often step in to support a fund that’s struggling. If a fund’s value starts to slip, a sponsor might intervene to help it stay on track by purchasing troubled assets or providing liquidity to maintain the $1 NAV.
While it is common for sponsors to step in to support their money market funds, it’s neither a guarantee nor a legal obligation. Indeed, the possibility that the sponsor may not provide this type of support to help a fund navigate adverse circumstances represents another risk for potential investors to keep in mind.
Regulatory protections and their limits
The SEC has significantly strengthened money market fund regulations since 2008. Despite this, there are limits to what regulations protect. Government money market funds carry the lowest risk profile because their holdings are backed by the U.S. government. Prime and municipal funds, which hold corporate and municipal debt, carry modestly more credit and liquidity risk.
Some investors might be surprised that money market funds are not protected by FDIC insurance. Unlike a bank account, which is federally insured up to $250,000, money market funds have no such protection.
If the fund loses money and neither the sponsor nor the government steps in to make investors whole, investors can lose their principal investment.
SEC regulations also allow funds to impose liquidity fees or temporarily suspend redemptions during periods of market stress. While these “gates” are meant to prevent disorderly or panicked fund withdrawals, they also mean that access could be delayed or come at a cost when your cash is needed most.
How to evaluate and manage money market fund risks
- Know what type of fund you’re in: Government funds are generally the most conservative choice because they carry the lowest risk. Prime funds might offer a bit more in yield, but they come with more exposure to corporate credit risk.
- Read about the fund and its disclosures: A fund’s prospectus and fact sheet are great resources for evaluating what the fund owns, how soon those investments will mature and the quality of the fund’s borrowers. Generally, you’ll want to look for funds that focus on high-quality issuers and keep their investment timelines short.
- Pay attention to fees: Because the returns on these funds are typically modest, fees can have a bigger impact on your bottom line. Some funds may also charge liquidity fees during times of market stress.
- Consider the sponsor: A fund backed by a large, well-capitalized financial institution has historically been more likely to receive sponsor support in a pinch than a smaller, independent fund. While the 2008 crisis showed that this support isn’t a legal guarantee, the strength of the sponsor is still an important factor.
- Diversify your cash holdings: For cash you cannot afford to lose, you may consider splitting it between a money market fund and an FDIC-insured bank account. This allows you to chase a higher yield with one part of your money while keeping the other part protected by a federal guarantee of up to $250,000.
The bottom line
Money market funds are generally excellent tools for managing cash with low volatility. And while they’re usually a safe choice, they are not FDIC-insured and their $1 NAV price is not guaranteed. History has shown that money market funds can face challenges when markets are under extreme stress. Using them effectively requires understanding these boundaries and structuring your cash so you are prepared for rare periods of market panic.
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Editorial staff, J.P. Morgan Wealth Management
